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
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).
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.