Liquidity Ratios

The liquidity ratios help in computing the accessibility of cash required for repayment of loans. There are basically two types of liquidity ratios and they are current ratio and quick ratio (or acid test ratio). The current ratio is a form of financial ratio, which calculates if a company has adequate source of wealth to repay its loans in the following 12 months or not.
This ratio represents the comparison between the current assets of a company to its current liabilities.

Current ratio can be represented with the help of the following formula:
Current ratio = Current Assets/Current Liabilities

For instance, if the current assets of a company amount to US$ 50,000,000 and the current liabilities of the same company amount to US$ 40,000,000, then the current ratio will be calculated as US$ 50,000,000 divided by US$ 40,000,000 and that is equivalent to 1.25. This signifies that each dollar owed by the company has US$ 1.25 present in the form of current assets. A current ratio of 2:1 between current assets to current liabilities is commonly regarded as satisfactory. Here the current assets are double of the current liabilities.
The current ratio denotes the market liquidity of a company and the strength of the company for meeting debts or liabilities for the short term. The adequacy of current ratios differs from one sector to another sector. If the current assets of a firm fall within the scope of the standard current ratio (2:1), then it is commonly assumed that the firm has commendable financial strength in the short term. In case the current liabilities are more than the current assets or where the current ratio is less than 1, then it is anticipated that the firm is going to face difficulties to satisfy its liabilities for the short term. In case the current ratio of a company is excessively high, it indicates that the company is not using its current assets in an effective manner.

Acid test ratio or quick ratio is also known as liquid ratio. It calculates the strength of a firm for utilizing its quick assets or near cash assets for instantly paying off the current liabilities of the firm. Quick assets are that type of assets, which may be presumptively changed over to cash in a rapid manner approximately at their book values. Examples of those assets are tradeable securities, cash, as well as accounts receivable. The acid test ratio describes the ability of a firm to sustain its functions in the usual manner with reserves of near cash (or current cash) in adverse financial circumstances. Intrinsically, the quick ratio entails a liquidation concept and does not acknowledge the rolling characteristics of current liabilities and current assets. In case of acid test ratio, a comparison is held between the investments (short term) and cash of a firm and the financial obligations that the firm is anticipated to obtain within the following 12 months.

The acid test ratio or quick ratio can be calculated with the help of the following formula:

Acid Test (Quick) Ratio = Current Assets – Inventory – Advance Payments/Current Liabilities – Bank Overdraft

Usually, the quick ratio is regarded as feasible at 1:1 or more; nevertheless it changes from one sector to another broadly.

 

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Last Updated on : 27th June 2013

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