Liquidity Ratios
Liquidity ratios express the ability of the firm to meet its short-term Obligations as when they become due. Creditors are interested to know whether the firms is in a position to meet its commitments on time or not. These ratios help in identifying the danger signals for the firm in advance. The important liquidity ratios are given below.
1. Current Ratio:
It is also called as working capital ratio. It is the ratio between current assets and current liabilities. The firm is in comfortable position if its current ratio is 2:1. It means for every rupee of current liability, there should be two rupees worth of current assets.
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐑𝐚𝐭𝐢𝐨 = 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐀𝐬𝐬𝐭𝐞𝐬 / 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐭𝐢𝐞𝐬
Current assets = Cash + cash in bank + marketable securities + short term investments + bills receivables + debtors + inventory + stock + work-in-progress + pre-paid expenses + incomes receivable (accrued income) etc.
Current liabilities = Expenses payable + bills payable + creditors + short term loans + income tax to be paid + dividend payable + bank overdraft + long term loans and debentures to be paid within one year + provision for tax + short term advances etc.
2. Quick Ratio:
It is also called as working Acid test ratio or liquid ratio. It is the ratio between quick assets and current liabilities. The firm is in comfortable position if its current ratio is 1:1. It means for every rupee of current liability, there should be one rupee worth of quick assets. Quick assets can be converted into cash quickly.
𝐐𝐮𝐢𝐜𝐤 𝐑𝐚𝐭𝐢𝐨 = 𝐐𝐮𝐢𝐜𝐤 𝐀𝐬𝐬𝐭𝐞𝐬 / 𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐭𝐢𝐞𝐬
Quick assets = All current assets except stock and prepaid expenses.
Example 1:
From the Balance Sheet of XYZ Co. Ltd., calculate liquidity ratios.
Balance Sheet (Rs. in thousands)
| Capital & Liabilities | Amount | Assets | Amount |
| Preference share capital | 100 | Land and Buildings | 225 |
| Equity share capital | 150 | Plant and machinery | 250 |
| General reserve | 250 | Furniture and Fixtures | 100 |
| Debentures | 400 | Stock | 250 |
| Creditors | 200 | Debtors | 125 |
| Bills payable | 50 | Cash at Bank | 250 |
| Outstanding expenses | 50 | Cash in hand | 125 |
| Profit and loss account | 100 | Prepaid expenses | 50 |
| Bank loan (Long term) | 200 | Marketable securities | 125 |
| Total | 1500 | Total | 1500 |
Current assets = Stock + Debtors + Cash at Bank + Cash in hand + Prepaid expenses + Marketable securities = 250 + 125 + 250 + 125 + 50 + 125 = 925
Current liabilities = Creditors + Bills payable + Outstanding expenses = 200 + 50 + 50 = 300
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐑𝐚𝐭𝐢𝐨 = 925 / 300 = 3.08: 1
Quick assets = Debtors + Cash at Bank + Cash in hand + Marketable securities = 125 + 250 + 125 + 125 = 625
𝐐𝐮𝐢𝐜𝐤 𝐑𝐚𝐭𝐢𝐨 = 625 / 300 = 2.08: 1