The strictest test of a company’s liquidity is the cash ratio. This metric utilizes only the most liquid of assets — cash equivalents and marketable securities — to determine how many times a company could pay off its liabilities over the next 12 months.
For companies that have very high accounts receivables, either because they sell expensive items that customers make long-term payments on or because they issue a lot of bad debt, this is often the best ratio to use. Here’s how to calculate it:
To use this equation, follow these steps:
Find the cash equivalents and marketable securities in the assets portion of the balance sheet and the current liabilities in the liabilities portion.
Add together cash equivalents and marketable securities.
Divide the answer from Step 2 by current liabilities.
This is the most conservative measure of a company’s liquidity, so if it’s high, then the company is at very low risk of insolvency.
