Financial Accounting

Liquidity Ratios – Meaning and Formula

Liquidity ratios measure the short term financial solvency of a business. Here the short term refers to a period of 12 months or lesser. The liquidity amounts to availability of assets which are in cash or near cash form or which could be converted in cash in quick time.

Examples of liquid assets involve cash in hand (of course), cash at bank, inventory (as it can be sold to generate the cash), marketable securities (they are also readily saleable), prepaid expenses etc. Typically the banks and different monetary establishments have the interest to know the liquidity position of their client business entities. Generally, better liquidity is considered a sign of sound business position. 

There are three sub-categories of liquidity ratios:

A. Current Ratio

The 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.

The formula of Current Ratio= Current Assets/ Current Liabilities 

Instance: Let say the whole present belongings of the corporate are value $8,000 and whole present liabilities quantity to $4,000. Right here, the present ratio will probably be $8,000/$4,000 = 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 liquid assets and current liabilities.

Liquid assets refer to these assets which may be converted into money in a 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 refer to those assets which are already cash or can be converted into cash in a short time such as bank balance and marketable securities.

Formula of Absolute Liquid Ratio = [Cash+Bank balance + Marketable Securities] / Current Liabilties

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