Liquidity Ratios
Meaning
Liquidity Ratios are calculated to judge the short-term financial position of the company. It helps to know whether company is able to meet its short-term liabilities.
Main liquidity ratios are:
1. Current ratio.
2. Quick ratio.
1. Current Ratio
Current ratio is the proportion of current assets to current liabilities.
Current Ratio = Current Assets: Current Liabilities.
Current Assets = Current Investments + Inventories (Excluding Spare Parts and Loose Tools) + Trade Receivables + Cash and Cash Equivalents + Short Term Loans and Advances + Other Current Assets
Current Liabilities = Short-Term Borrowings + Trade Payables + Other Current Liabilities + Short-term Provisions
Significance:
The excess of current assets over current liabilities provides a measure of safety margin available against uncertainty in realization of current assets and flow of funds. The ratio should be reasonable.
A very high current ratio implies heavy investment in current assets which is not a good sign as it reflects under utilization or improper utilization 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. Normally, it is advocated to have this ratio as 2:1.
2. Quick Ratio (Acid-Test Ratio/Liquid Ratio)
It is the ratio of quick (or liquid) asset to current liabilities.
Quick ratio = Quick Assets: Current Liabilities.
Quick assets are defined as those assets which are quickly convertible into cash. Quick Assets (Liquid Assets) =Current Assets-(Stock and prepaid expenses).
Significance:
It measures the capacity of the business to meet its short-term obligations. Because of exclusion of non-liquid current assets, it is considered better than current ratio.
Standard of this ratio is 1:1.
A very low ratio is very risky, and a high ratio indicates use of resources in less profitable short-term investments.