Liquidity ratios measure the short term financial solvency of a business. Typically the banks and different monetary establishments have an interest to know the liquidity position of their client business entities. There are three sub-categories of liquidity ratios:
A. Current Ratio: Current ratio is often known as the Working Capital Ratio. It establishes the connection between the current ratios and current liabilities. It reveals the business ability to satisfy its current liabilities out of current assets.
Formula of present ratio= Present Belongings/ Present Liabilities
Instance: Let say the whole present belongings of the corporate are value $eight,000 and whole present liabilities quantity to $four,000. Right here, the present ratio will probably be $eight,000/$four,000 = 2:1
B. Liquid Ratio or Acid Test Ratio: Liquid ratio/acid test ratio/quick ratio are the same things. This ratio establishes the relationship between the liquid assets and current liabilities. Liquid assets refers to these assets which may be converted in to money in short time period. It excludes the stock and prepaid expenses, as stock will take time to sell and collect money whereas the prepaid expenses are usually not going to provide any benefit in cash.
Therefore, liquid assets = current assets – (Stock+prepaid expenses)
Formula of liquid or acid test ratio= [Current Assets – (Inventory+Prepaid Expenses)]/ Current Liabilities
Example: Continuing with the example used for current ratio, let’s assume the whole current assets consist of stock worth $2,000 the liquid ratio will be [8000-2000]/4000 = 1.5:1.
C. Absolute Liquid Ratio: In many countries it is also known as the Cash Ratio. This ratio establishes the relationship between the cash or near cash assets to the current liabilities. Here, the near cash assets refers to those assets which are already cash or can be converted in to cash in short time such as bank balance and marketable securities.
Formula of Absolute Liquid Ratio = [Cash+Bank balance + Marketable Securities]/Current Liabilties