Liquidity Ratios
Liquidity Ratios
The term liquidity refers to that ability of the firm to meet its obligations as and when due. The current liability of the company meets by the realising amount from current assets. The current assets may be in the form of liquid or near to liquid. The sufficient of insufficient of currents assets should be assessed by comparing the current assets with short liabilities. If the current assets of the company are more than the current liability it will show that liquidity position is satisfactory and on another hand if the current assets of the company are less than the current liability that means the liquidity position of the company is not satisfactory.
Current Assets ratio: –
The current ratio defined the relation between current assets or current liability. Current assets ratio is most widely used by companies to assess the liquidity position or short-term financial position of the concern. This ratio is also known as the working capital ratio. Current ratio can be calculated with the help of formula;-
Current ratio: – Current Assets / Current liabilities |
The two component of current ratio:- current assets and current liabilities. In 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 expenses or accrued expense, 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 is an indication that a firm is able to meet its obligations in time as and when becomes due. It shows liquidity position is satisfactory. On the other hand, the low current ratio indicates that a firm is unable to pay its obligation in time as and when becomes due. It shows liquidity position of the concern is unsatisfactory. Otherwise, the rule of thumb is 2:1 that means current assets should be doubled than current liabilities.
For an example:-
Current assets of the company are $2, 50,000 and current liabilities as $ 1, 00,000; current ratio will be calculated as follow;
Current ratio= Current assets / current liabilities 2500000/100000 2.5:1 |
The current ratio of company 2.5 means that current assets of the company are 2.5 times of liabilities. It means company liquidity position is satisfactory, they can meet its current liabilities in time as and when becomes due.
Quick Ratio: –
The quick ratio is also called liquid or Acid test ratio. The quick ratio represents the relationship between the quick assets and current liabilities. Quick assets mean those assets which can convert into cash within the short period of time 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 |
As a rule of thumb 1:1 is considered the most satisfactory position of quick ratio.
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 |
Quick ratio = Quick assets / current liabilities Quick assets = $220000+ $15000+$ 110000 Current liabilities = $ 150000+ $30000 Quick Ratio= 345000/ 180000 Quick ratio = 1.916:1 |
The quick ratio 1.96 is the satisfactory ratio. It shows that a firm has the ability to meets its current liability or liquid liabilities in time as and when 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 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 the 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 quite satisfactory because it is much higher than the rule of thumb i.e. 0.5.