LIQUIDITY RATIO

LIQUIDITY RATIO

1.Current Ratio

Current Ratio  =  Current Assets : Current Liabilities

or

Current   Assets

Current Liabilities

Current assets include cash in hand, bank balance, debtors, bills receivable,stock, prepaid expenses, accrued income, and short-term investments(marketable securities).

Current liabilities include creditors, bills payable, outstanding expenses, provision for taxation net of advance tax, bank overdraft, short-term loans, income received in advance, etc.

Significance: It provides a measure of degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a measure of safety margin available against uncertainty in realisation of current assets and flow of funds. The ratio should be reasonable. It should neither be very high or very low. Both the situations have their inherent disadvantages. A very high current ratio implies heavy investment in current assets which is not a good sign as it reflects under utilisation or improper utilisation of resources. A low ratio endangers the business and puts it at risk of facing a situation where it will not be able to pay its short-term debt on time. If this problem persists, it may affect firms credit worthiness adversely. Normally, it is advocated to have this ratio as 2:1.

2. Quick Ratio

It is the ratio of quick (or liquid) asset to current liabilities. It is expressed as

Quick ratio = Quick Assets : Current Liabilities  or 

Quick   Assets

Current Liabilities

The quick assets are defined as those assets which are quickly convertible into cash. While calculating quick assets we exclude the closing stock and prepaid expenses from the current assets. Because of exclusion of non-liquid current asset, it is considered better than current ratio as a measure of liquidity position of the business. It is calculated to serve as a supplementary check on liquidity position of the business and is therefore, also known as ‘Acid-Test Ratio’


Significance: The ratio provides a measure of the capacity of the business to meet its short-term obligations without any flaw. Normally it is advocated to be safe to have a ratio of 1:1 as unnecessarily low ratio will be very risky and a high ratio suggests unnecessarily deployment of resources in otherwise less profitable