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Accounting Ratios

Liquidity Ratios

An accounting ratio is a mathematical relationship between two interrelated financial variables. Hence, Ratio analysis is the process of interpreting the accounting ratios meaningfully and taking decisions on this basis. Examples of most common ratios are Current Ratio, Equity Ratio, Debt to Equity Ratio, Fixed Assets Turnover Ratio, etc.

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Liquidity Ratios

A business requires liquid funds in order to meet its short-term commitments. Liquidity is the ability of an organization to pay the amount as and when it becomes due, to the stakeholders.

Thus, we need to calculate the Liquidity ratios to measure liquidity. These ratios are short-term in nature. The creditors always want to know the liquidity position of the entity because of their financial stake.

When an organization is unable to fulfill its short-term commitments it adversely affects its credibility as well as the credit rating.

Also, this may result in bankruptcy or closure. It is noteworthy here that excess and insufficient liquidity both are not good for the organization.

Types of Liquidity Ratio

  • Current Ratio
  • Quick Ratio or Acid test Ratio
  • Cash Ratio or Absolute Liquidity Ratio
  • Net Working Capital Ratio

Current Ratio

It is one of the most common ratios for measuring the short-term solvency or the liquidity of the firm. It is the ratio between the Current Assets and Current Liabilities.

In other words, it measures whether there are enough current assets to pay the current debts with a margin of safety for potential losses in the realization of the current assets.

Usually, the ideal current ratio is 2:1. However, the ideal ratio depends on the nature of the business and the characteristics of its current assets and current liabilities. Thus,

$$ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$

Where,

Current Assets = Sundry Debtors + Inventories + Cash-in-hand + Cash-at-Bank + Receivables + Loans       and Advances + Disposable Investments + Advance Tax

Current Liabilities = Creditors + Short-term Loans + Bank Overdraft + Cash Credit + Outstanding expenses + Provision for Taxation + Dividend payable

Learn more about Solvency Ratio here in detail.

Quick Ratio

It is also known as Acid-test Ratio. Quick Ratio measures the relationship between Quick Assets and Current Liabilities. It measures whether there are enough readily convertible quick funds to pay the current debts.

Thus, it is better than the Current Ratio. Quick assets include only cash and near cash assets. It does not include inventories as they are not readily convertible into cash.


Also, it does not include prepaid expenses as these are paid in advance and cannot be converted into cash. The ideal Quick Ratio or Acid-test Ratio is 1:1. Thus,

$$ \text{Quick Ratio or Acid-test Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}} $$

Where,

Quick Assets = Current Assets – Inventories – Prepaid Expenses

Current ratio and liquidity ratio

Cash Ratio or Absolute Liquidity Ratio

It measures the absolute liquidity of the firm. It measures whether a firm can pay the current debts by using only the cash balances, bank balances and marketable securities.

We do not include Inventory and Debtors because there is no guarantee of their realization. Thus,

 $$ \text{Cash Ratio} = \frac{\text{Cash and Bank Balances + Marketable Securities + Current Investments}}{\text{Current Liabilities}} $$

Net Working Capital Ratio

It is a measure of cash flow. The answer to this ratio should be positive. Usually, the bankers keep an eye on this ratio to see whether there is a financial crisis or not. Thus,

Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short-term bank borrowing)

Solved Examples of Liquidity Ratios

From the following particulars calculate the liquidity ratios:

Particulars Amount
Inventory 140000
Sundry Debtors 280000
Cash 50000
Bills receivable 20000
Creditors 300000
Bank Overdraft 50000

Ans.

  1. $$ \text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{490000}{350000} = 1.4:1 $$

Current Assets = Sundry Debtors + Inventories + Cash-in-hand + Bills Receivable

= 280000 + 140000 + 50000 + 20000

= 490000

Current Liabilities = Creditors + Bank Overdraft

= 300000 + 50000

= 350000

  1. $$ \text{Quick Ratio or Acid-test Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}} = \frac{350000}{350000} = 1:1 $$

Quick Assets = Current Assets – Inventories

= 490000 – 140000

= 350000

  1. $$ \text{Cash Ratio} = \frac{\text{Cash Balance}}{\text{Current Liabilities}} = \frac{50000}{350000} = 0.14:1 $$
  1. Net Working Capital Ratio = Current Assets – Current Liabilities (exclude short-term bank borrowing)

= 490000 – 300000

= 190000

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