What is Liquidity Ratio?
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
Current Ratio
Quick Ratio or Acid test Ratio
Cash Ratio or Absolute Liquidity Ratio
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
Stock
Sundry Debtors
Cash/ Bank Balances
Bills receivable
Accruals
Short term loans given
Short term Securities
Current Liabilities
Creditors
Outstanding Expenses
Short Term Loans taken
Bank Overdrafts
Provision for Taxation
Proposed Dividend
Current Ratio Formula
Current Ratio = Current Assets / Current Liabilities
Where,
Current Assets = Sundry Debtors + Inventories + Cash-at-Bank + Cash-in-hand + Receivables + Loans and Advances + Advance Tax + Disposable Investments
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 Formula
Cash Ratio= Cash and Bank Balances + Marketable Securities + Current Investments / Current Liabilities
Net Working Capital Ratio
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 Formula
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
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
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
Cash Ratio = Cash Balance / Current Liabilities
Cash Ratio = 50,000 / 380,000= 0.13:1
Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short-term bank borrowing)
Net Working Capital Ratio = 530,000- 350,000= 180,000
FAQs on Liquidity Ratios: Importance and Calculation
1. What is the difference between the Current Ratio and the Quick Ratio?
The quick ratio is considered a better liquidity ratio formula and a better measure of a firm’s liquidity than the current ratio. Quick ratio is used to calculate if the readily convertible quick funds are enough to pay the current debts. This ratio is calculated by using the quick assets that include only cash and near-cash or readily convertible into cash assets. It does not include inventories as they cannot be readily converted into cash. Prepaid expenses are also not included as they are paid in advance and cannot be converted into cash.
2. What are Liquidity Coverage Ratio and Statutory Liquidity Ratio?
The liquidity coverage ratio requires the banks to hold a sufficient amount of high-quality liquid assets to fund cash outflows for 30 days. Liquidity coverage ratio is similar to liquidity ratios as it is also a measure of the company’s ability to meet its short-term financial obligations. Statutory Liquidity Ratio is the ratio of liquid assets to Net Demand and Time Liabilities (NDTL).
3. What Is Liquidity and Why Does It Matter to Companies?
The ease with which cash may be obtained to pay bills and other short-term obligations is referred to as liquidity. Liquid assets are those that can be sold quickly, such as stocks and bonds (although cash is, of course, the most liquid asset of all). Businesses need adequate cash on hand to satisfy their expenses and responsibilities, so they can pay vendors, keep payroll up to date, and keep their operations running smoothly on a daily basis.
4. Why Do Different Liquidity Ratios Exist?
The ease with which cash may be obtained to pay bills and other short-term obligations is referred to as liquidity. Liquidity ratios divide current assets by current liabilities to determine a company's capacity to meet short-term obligations (CL). The fast ratio includes cash equivalents (such as money market assets) as well as marketable securities and accounts receivable, whereas the cash ratio just considers cash on hand divided by CL. All current assets are included in the current ratio.
5. What Happens If a Company's Ratios Show It Is not Liquid?
A number less than one represents a low ratio. This typically indicates that a corporation will struggle to meet or will be unable to meet its short-term obligations. This can also indicate a company's financial difficulties. Even healthy organizations can have a liquidity crisis in this situation if events emerge that make it difficult to meet short-term obligations, such as repaying loans and paying employees or suppliers. The worldwide credit crunch of 2007-09, for example, was a recent example of a wide-ranging liquidity crisis, in which many companies were unable to get short-term financing to meet their urgent obligations.
6. What Is the Current Ratio?
The current ratio, also known as the working capital ratio, compares a company's assets that may be converted into cash within a year to its liabilities that must be paid off within a year. It is one of a few liquidity ratios that evaluate a company's ability to use cash to fulfill short-term demands, along with the quick ratio, or acid test, and the cash ratio. 1
Cash, cash equivalents (investments that mature in three months or less and may be easily turned into cash, such as government bonds, commercial paper, and money market funds), accounts receivable, and inventories are all examples of current assets on the balance sheet.
Accounts payable, income taxes payable, wages payable, and dividends declared, which are amounts owed to suppliers, income taxes owed to the federal government, employee wages earned but not yet paid, and dividends approved and declared by the board of directors but not yet paid, are all examples of current liabilities.
7. Where can I find notes and questions on Liquidity Ratios?
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