Liquid funds help a business in meeting its short-term expenses commitments. Liquidity can be defined as an organization’s ability to meet an expense or settle a liability towards its stakeholders, as and when it becomes due. It is a parameter that gives a picture of the solvency of the firm.
To measure the liquidity, we need to calculate the liquidity ratios. These ratios give a short-term answer as the creditors are interested in the current liquidity position of the entity. If the organization is not in a position to meet its short-term commitments, it has an adverse effect on its credit rating and credibility. If the organization is not able to honor its financial commitments, it can result in its bankruptcy or closure. The liquidity of the organization must neither be insufficient nor should it be excessive.
Types of Liquidity Ratio
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Current Ratio
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Quick Ratio or Acid test Ratio
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Cash Ratio or Absolute Liquidity Ratio
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Net Working Capital Ratio
Let’s look at these ratios in detail.
Current Ratio
One of the most common ratios for measuring the short-term liquidity of the firm is the current ratio. This ratio is also called the working capital ratio. It measures whether the current assets of the firm are enough to pay the current liabilities or debts of the firm. This ratio keeps a margin of safety for any potential losses that might occur during the realization of the current assets. It can be calculated as the ratio between the Current Assets and Current Liabilities.
The ideal current ratio is 2:1 but it also depends on the characteristics of the current assets and current liabilities along with the nature of the business of the firm. Let’s see the heads that are included under current assets and current liabilities.
Current Assets
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Stock
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Sundry Debtors
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Cash/ Bank Balances
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Bills receivable
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Accruals
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Short term loans given
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Short term Securities
Current Liabilities
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Creditors
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Outstanding Expenses
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Short Term Loans taken
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Bank Overdrafts
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Provision for Taxation
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Proposed Dividend
Current Ratio Formula
Current Ratio = Current Assets / Current Liabilities
Where,
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Current Assets = Sundry Debtors + Inventories + Cash-at-Bank + Cash-in-hand + Receivables + Loans and Advances + Advance Tax + Disposable Investments
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Current Liabilities = Creditors + Short-term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Dividend payable + Provision for Taxation
Quick Ratio
Quick Ratio is also known as Acid-test Ratio. It is a measure of the liquidity calculated on the basis of the relationship between Quick Assets and Current Liabilities. It is used to calculate if the readily convertible quick funds are enough to pay the current debts. The ideal Quick Ratio or Acid-test Ratio is 1:1.
Acid-Test Ratio Formula or Quick Ratio Formula
Quick Ratio= Quick Assets / Current Liabilities
Where,
Quick Assets = Current Assets – Inventories – Prepaid Expenses
Cash Ratio or Absolute Liquidity Ratio
The cash ratio is used to measure the absolute liquidity of the firm. It calculates whether a firm can use only its cash balances, bank balances, and marketable securities to pay its current debts. Inventory and Debtors are not included while calculating this ratio because there is no guarantee of their realization.
Cash Ratio= Cash and Bank Balances + Marketable Securities + Current Investments / Current Liabilities
It is a measure of the cash flow and this ratio should be positive. This ratio is very important for the bankers as it helps them gauge if there is a financial crisis in the firm.
Net Working Capital Ratio= Current Assets – Current Liabilities (exclude short-term bank borrowing)
Solvency Ratios vs. Liquidity Ratios
Solvency ratios, in contrast to liquidity ratios, assess a company’s capacity to satisfy all of its financial obligations, including long-term debts. Liquidity focuses on current or short-term financial accounts, whereas solvency refers to a company’s overall capacity to satisfy debt commitments and maintain its operations.
To be solvent, a business must have more total assets than total liabilities; to be liquid, it must have more current assets than current liabilities. Liquidity ratios provide an early assessment of a company’s solvency, despite the fact that solvency is not directly related to liquidity.
Divide a company’s net income and depreciation by its short- and long-term obligations to get the solvency ratio. This determines if a company’s net income is sufficient to cover all of its liabilities. A corporation with a greater solvency ratio is generally thought to be a better investment.
Solved Example on Liquidity Ratios
1. Calculate the different liquidity ratios from the following particulars
|
Particulars |
Amount |
|
Inventory |
150,000 |
|
Cash |
50,000 |
|
Sundry Debtors |
300,000 |
|
Creditors |
350,000 |
|
Bills Receivable |
30,000 |
|
Bank Overdraft |
30,000 |
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Current Ratio= Current Assets/ Current Liabilities
Current Assets = Sundry Debtors + Inventories + Cash-in-hand + Bills Receivable
Current Liabilities = Creditors + Bank Overdraft
Current Assets= 300,000 + 150,000+ 50,000+ 30,000= 530,000
Current Liabilities = 350,000+ 30,000= 380,000
Current Ratio= 530,000 / 400,000= 1.3 :1
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Quick Ratio or Acid Test Ratio= Quick Assets / Current Liabilities
Quick Assets = Current Assets – Inventories
Quick Assets= 530,000 – 150,000= 380,000
Quick Ratio or Acid Test Ratio= 380,000 / 380,000 = 1:1
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Cash Ratio = Cash Balance / Current Liabilities
Cash Ratio = 50,000 / 380,000= 0.13:1
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Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short-term bank borrowing)
Net Working Capital Ratio = 530,000- 350,000= 180,000