Liquidity is simply defined as the ability of a company to convert its assets into cash quickly or in the short term (usually encompassing a 12-month period). When your business is liquid, it means your company can easily turn assets into cash and pay-off its short-term debts or liabilities to creditors.

Liquidity is important when applying for a loan since this will be used by banks and other creditors to gauge your company's ability to pay off your debts and not go bankrupt. It can also be used to make financial and management decisions. For example, would you continue to buy inventory with cash to get a discount from your supplier, but risk not having enough cash to pay for wages, taxes, and interest on your loan?

There are two common ways to measure your company's liquidity just by looking at your accounting sheets:

1. Current Ratio

Current ratio is calculated as the current assets divided by current liabilities (Current assets / Current Liabilities). It is often expressed as a factor such as 2:1 (2 current assets per 1 current liability). The term current means receivable or payable within the next 12 months. Current assets then is defined as cash + accounts receivable + stocks or inventory while the current liabilities is simply all short term debts. Both current assets and current liabilities can be easily obtained from your business' balance sheet.

If the current assets are lower than current liabilities, then it may indicate that the company is in a bad financial standing. It is commonly accepted that a ratio of 2:1 is ideal but use it only as a guide since the situation of each company is unique.

2. Acid Test or Quick Ratio

We stated above that current assets include a business' stocks or inventories. Since it's possible for a business not to sell all of its stocks in the near future, we can then take this out of the equation to have a better gauge at a business' liquidity. Acid test is simply the ratio between the current assets minus the stocks/inventories, and divided by the current liabilities ( [current assets - stocks] / current liabilities).

The acid test, which is sometimes called as the 'quick ratio', is probably a better measure of a business' liquidity compared to the current ratio since it might be difficult for businesses to dispose of its stocks in the short term. People are saying that an acid test ratio of 1:1 is ideal.

But then again, we cannot assume that a company is in bad shape if it has a ratio of less than 1:1. It's very unlikely for all liabilities to be due on the same month (think of taxes, wages, credits from suppliers, etc). A business may receive payments from debtors, and may even make enough sales to meet its current liabilities as they become due.