Liquidity Ratios

(a)    Current Ratio

The short-term financial position of a concern may be ascertained by a comparison of current assets and current liabilities. This information may also be put in the form of a ratio known as current ratio.

Current Ratio = Current Assets / Current Liabilities  say, Rs 4,00,000 / Rs 2,00,000

where, Current Assets = Debtors + Bills Receivable  + Inventory
                                        + Loan & Advances + Cash in hand and at bank
                                        + Prepaid expenses + Short-term, Investments, etc.

Inventory = Raw Materials-Work in Process + Finished Goods + Stores & Spares

Current Liability = Creditors + Bills payable + advance received
                               + Bank overdraft + Outstanding liabilities for expenses
                               + Interest accrued.

The current ratio in the above case is 2:1 which is considered to be ideal as per standard laid down in this regard.

Implications of Current Ratio. It is suggested that in order to ensure solvency of the concern, current assets should be at least twice the amount of current liabilities. The current ratio of 2:1 implies that each rupees of current liabilities is supported by two rupees of current assets and therefore the short-term financial position is considered to be favorable. The suppliers of capital insist on an adequate current ratio.

This ratio is one of the most commonly used ratios of measuring solvency or financial strength. Howver, the current ratio of 2:1 is not a conclusive proof of the solvency of a firm. The effectiveness of 2:1 current ratio depends upon the nature of business the composition of assets and also on turnover of current assets.

Debt-equity ratio is sensitive to a number of factors because of which even a ratio of 2:! is not an adequate test of debt paying capacity of the firm. The examples of such factors are as under:

(i)    Large stocks may have been accumulated for seasonal demand or in anticipation of a rise in price, but stocks may be obsolete or slow moving.
(ii)    Debtor may be bad or doubtful; recovery or collection may be very slow.
(iii)    Trade investment may not be easily marketable.
(iv)    Contingent liabilities may not have been provided for in the accounts.
(v)    The company may possess assets earmarked for discharge of specific liabilities.

In order to get dependable results, it is essential that the effect of above factors should be eliminated. To account for the influence of first factor, acid-test ratio or quick ratio is also calculated along with the current ratio.

(b)    Quick/Liquid or Acid Test Ratio

It measures the firm’s capacity to pay off claims of current creditors immediately. It is also know as acid test ratio.   

Quick Ratio = Liquid Assets / Current Liabilities   say Rs 2,00,000 / Rs. 2,00,000


where, Liquid Assets = Cash in hand and at bank
                                       + Debtors less Provision for Bad and Doubtful Debts
                                       + Realizable Investment
                                       + Any other current asset which can be realized immediately.

Significance of  Quick Ratio. The liquid assets eliminate inventory, prepaid expense, etc. from the current assets as these items cannot be converted into cash immediately. he quick ratio in the above case is 1:1  which is considered to be ideal as per standard laid down in this regard. However, this ratio must be considered together with the current ratio to test the short-term financial strength and the immediate solvency of the firm. The ideal current and quick ratios will differ form industry to industry.

 The quick ratio is very useful in measuring the liquidity of a company. It measures the ability of company to meet its most current obligation. It is used as a complementary ratio to the current ratio. It provides a more stringent test of solvency; that is why, ti is also called acid test ratio. A company may have very large amount of stock and, therefore, its current ratio may be high. In such a case, if the liquid ratio is low, the analyst would immediately know that the company does not have good liquidity position and its solvency is n doubt.

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