Liquidity Ratio
A company will have both assets and liabilities associated with its name. There are also current assets and current liabilities in addition to those that are of a more permanent type. These obligations have a very short maturity and are quite straightforward to convert into cash. The link between such current assets and current liabilities is the subject of the liquidity ratios that are discussed.
The capacity of a company to meet its immediate financial obligations, also known as current liabilities, is evaluated using liquidity ratios. It demonstrates the levels of liquidity, which indicates how much of the company’s assets can be promptly turned into cash in order to meet the company’s financial commitments when they come due.
It is a measurement that indicates not only how much cash is available but also how readily current assets may be turned into cash or marketable securities. Let’s take a look at some of the most relevant liquidity ratios right now, shall we?
Current Ratio
The current ratio is also known as the working capital ratio. It will measure the relationship between current assets and current liabilities. It measures the firm’s ability to pay for all its current liabilities, due within the next one year by selling off all their current assets. The formula for is as follows
Current Ratio = Current Assets/Current Liabilities
Current Assets include,
- Stock
- Debtors
- Cash and Bank Balances
- Bills receivable
- Accruals
- Short term loans that are given
- Short term Securities
Current Liabilities include
- Creditors
- Outstanding Expenses
- Short Term Loans that are taken
- Bank Overdrafts
- Provision for taxation
- Proposed Dividend
The industry guideline states that a 2:1 current ratio is desirable. In other words, a company should have at least twice as many current assets as current liabilities. However, if the ratio is too high, it can mean that some present assets are underutilised and laying idle. So it’s important to keep the two in the proper proportion.
Quick Ratio
The other important one of the liquidity ratios is Quick Ratio, also known as a liquid ratio or acid test ratio. This ratio will measure a firm’s ability to pay off its current liabilities (minus a few) with only selling off their quick assets.
Now Quick assets are those which can be easily converted to cash with only 90 day’s notice. Not all current assets are quick assets. Quick assets generally include cash, cash equivalents, and marketable securities. The formula is
Quick Ratio = Quick Assets/(Current Liabilities/Quick Liabilities)
Quick Assets = All Current Assets – Stock – Prepaid Expenses
Quick Liabilities = All Current Liabilities – Bank Overdraft – Cash Credit
The optimum quick ratio is thought to be 1:1, allowing the company to pay off all of its short-term obligations without experiencing any liquidity issues, i.e., without having to sell any investments or fixed assets. It is a strict measure of liquidity since it excludes stock, which is one of the main current assets for most businesses. Since it is more useful than the current ratio, many companies think it is a superior measure of liquidity.
This is an even more rigorous liquidity ratio than quick ratio. Here we measure the availability of cash and cash equivalents to meet the short-term commitment of the firm. We do not consider all current assets, only cash. Let us see the formula,
Absolute Cash ratio = (Cash+ Bank Balance + Marketable Securities) /Current Liabilities
As you can see, this ratio measures the cash availability of the firm to meet the current liabilities. There is no ideal ratio, it helps the management understand the level of cash availability of the firm and make any changes required.
However, if the ratio is greater than 1 it indicates poor resource management and very high liquidity. And high liquidity may mean low profitability.
