How to calculate liquidity ratios?- With examples

The term liquidity refers to the ability of the firm to meet its obligations as and when due. The current liability of the company meets the realising amount from current assets.

The current assets may be in the form of liquid or near-to-liquid. The sufficient or insufficient current assets should be assessed by comparing the current assets with short liabilities.

Suppose the current assets of the company are more than the current liability. In that case, it will show that the liquidity position is satisfactory. On the other hand, if the company’s current assets are less than the current liability, that means the company’s liquidity position is not satisfactory.

Current Assets Ratio

The current ratio defines the relation between current assets and current liability. Companies most widely use the current assets ratio to assess the concern’s liquidity position or short-term financial position. This ratio is also known as the working capital ratio.

The current ratio can be calculated with the help of the formula:

Current Ratio: Current Assets / Current liabilities

The two-component of the current ratio:- current assets and current liabilities. Current assets include cash in hand; cash at the bank; Marketable securities (short-term); short-term investment; bills receivable; Sundry debtors; Inventories; work in progress; and prepaid expenses.

Current liabilities include outstanding or accrued expenses, Bills payable, Sundry creditors, short-term advance, income-tax payable, dividend payable and bank overdraft ( if not the permanent arrangement).

Interpretation of current ratio: – High current ratio indicates that a firm can meet its obligations in time as and when it becomes due. It shows the liquidity position is satisfactory.

On the other hand, the low current ratio indicates that a firm cannot pay its obligation in time as and when it becomes due. It shows the liquidity position of the concern is unsatisfactory. Otherwise, the rule of thumb is 2:1 which means current assets should be double current liabilities.

For example:-

Current assets of the company are $2,50,000, and the current liabilities as $ 1,00,000; the current ratio will be calculated as follow;

Current ratio = Current Assets / Current Liabilities
= 2500000/100000 = 2.5:1

The current ratio of the company is 2.5 means that the company’s current assets are 2.5 times of liabilities. It means the company’s liquidity position is satisfactory, and it can meet its current liabilities in time and when it becomes due.

Quick Ratio

The quick ratio is also called the liquid or Acid test ratio. The quick ratio represents the relationship between quick assets and current liabilities.

Quick assets are those assets that can convert into cash within a short period without loss of value.

Quick Ratio = Quick Assets / Current liabilities Quick Assets= Current assets – (Inventory + prepaid expenses) *Inventory means all types of stock i.e. Finished, work in progress and raw material

A higher Quick Ratio indicates that a company is more capable of meeting its short-term liabilities with its most liquid assets. A ratio of 1 or higher is generally considered acceptable, while a ratio below 1 may indicate that the company may struggle to meet its short-term obligations.

For example

The information is given XYZ Ltd as such

Liabilities	Amount ($)	Assets	Amount ($)
Bank Loan Sundry creditors Bills payable Debentures Plant and machinery Furniture	100000   150000 30000 200000 300000 1000000	Stock in trade Sundry debtors Cash in hand Cash at bank Short term investment Marketable securities Prepaid insurance	135000 220000 15000 110000 150000 100000 5000

The quick ratio of 1.96 is a satisfactory ratio. It shows that a firm can meet its current or liquid liabilities in time and when they become due.

Absolute liquid assets

Absolute liquid assets included cash in hand and cash at bank and marketable securities. The rule of thumb for this ratio is that 0.5:1 is considered satisfactory.

Absolute liquid ratio=   Absolute Liquid assets / Current liabilities Absolute liquid assets = Cash & Bank + short term securities

Example: – The continue above example of XYZ Ltd Company calculates the absolute liquid ratio

Solution

Absolute liquid ratio=   Absolute Liquid assets / Current liabilities  

Absolute liquid assets = Cash & Bank + Short term securities
=$15000+$110000+ $100000 =$225000
Current liabilities =$ 150000+ $30000  = $ 180000
Absolute liquid ratio = 225000/180000 =1.25:1

The ratio of 1.25 is entirely satisfactory because it is much higher than the rule of thumb, i.e. 0.5.