Liquidity indicates a company’s capability of meeting debt obligations by converting assets into cash and equivalents. Companies with a favorable liquidity position have always been in demand as these are believed to have the potential to boost portfolio returns.

However, one should be cautious before investing in liquid stocks. While a high liquidity level may mean that the company is meeting its obligations at a faster rate compared to others in its domain, it may also indicate that the company is failing to use its assets efficiently.

Hence, one should consider the efficiency level of a company in addition to its liquidity to identify potential winners as this combination is indicative of underlying financial strength.

Measures to Identify Liquid Stocks

Current Ratio: It measures current assets relative to current liabilities. This ratio is used for measuring a company’s potential to meet both short- and long-term debt obligations. Thus, a current ratio — also known as working capital ratio — below 1 indicates that the company has more liabilities than assets. However, a high current ratio does not always indicate that the company is in good financial shape. It may also mean that the company has failed to utilize its assets significantly. Hence, a range of 1 to 3 is considered ideal.

Quick Ratio: Unlike current ratio, quick ratio – also called “acid-test ratio” or “quick assets ratio” – indicates a company’s ability to pay short-term obligations. It considers inventory excluding current assets relative to current liabilities. Like the current ratio, a quick ratio of greater than 1 is desirable.

Cash Ratio: This is the most conservative ratio among the three, as it takes into account only cash and cash equivalents, and invested funds relative to current liabilities. It measures a company’s ability to meet its current debt obligations using the most liquid of assets. Though a cash ratio higher than 1 may point to sound financials, a high number may indicate inefficiency in cash utilization.