Liquidity ratios examine how easily the firm could meet its short-term obligations.
The current ratio compares the level of the most liquid assets (current assets) against that of the shortest maturity liabilities (current liabilities). A high current ratio indicates high level of liquidity and less risk of financial trouble. Too high a ratio may point to unnecessary investment in current assets, failure to collect receivables or a bloated inventory, all negatively affecting earnings. Too low a ratio implies illiquidity and the potential for being unable to meet current liabilities and random shocks like strikes that may temporarily reduce the inflow of cash.
The quick ratio, or acid test, is similar to the current ratio, but it is a more conservative measure. It subtracts inventory from the current assets side of the comparisons because inventory may not always be quickly converted into cash or may have to be greatly marked down in price before it can be converted into cash.
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