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Liquidity ratios measure the capacity of the business to meet short term financial commitments as they become due.
The current ratio (also called the working capital ratio) is a measure of the solvency or liquidity of your business. It tells you whether your business has enough current assets to meet its short term financial obligations (current liabilities) as they become due.
The formula used to calculate the current ratio is:
Current ratio = current assets ÷ current liabilities
The higher the current ratio, the better the capacity to meet short term financial commitments. A current ratio of 2:1 (which means the business has current assets of $2 for every $1 of current liabilities) is regarded as desirable for a healthy business. However, the circumstances of every industry or business are different so consider how your business operates and set an appropriate ratio. As a general rule, try to achieve a current ratio above 1:1 and as close to 2:1 as possible.
The quick ratio is a measure of the liquidity of your business. It measures the level of all assets that can be quickly convertible into cash and used to meet short term liabilities. The quick ratio provides a more conservative measure than the current ratio because it excludes inventory.
The formula used to calculate the quick ratio is:
Quick ratio = (Current assets - inventory) ÷ Current liabilities