How to calculate liquidity ratios?- With examples
The term liquidity refers to the ability of the firm to meet its obligations as and when due. The current liability of the company meets the realising amount from current assets.
The current assets may be in the form of liquid or near-to-liquid. The sufficient or insufficient current assets should be assessed by comparing the current assets with short liabilities.
Suppose the current assets of the company are more than the current liability. In that case, it will show that the liquidity position is satisfactory. On the other hand, if the company’s current assets are less than the current liability, that means the company’s liquidity position is not satisfactory.
Current Assets Ratio
The current ratio defined the relation between current assets or current liability. Companies most widely use the current assets ratio to assess the concern’s liquidity position or short-term financial position. This ratio is also known as the working capital ratio.
The current ratio can be calculated with the help of the formula:
Current Ratio: Current Assets / Current liabilities
The two-component of the current ratio:- current assets and current liabilities. Current assets include cash in hand; cash at the bank; Marketable securities (short-term); short-term investment; bills receivable; Sundry debtors; Inventories; work in progress; and prepaid expenses.
Current liabilities include- outstanding expenses or accrued expenses, Bills payable, Sundry creditors, short-term advance, income-tax payable, dividend payable and bank overdraft ( if not the permanent arrangement).
Interpretation of current ratio: – High current ratio is an indication that a firm can meet its obligations in time as and when it becomes due. It shows the liquidity position is satisfactory.
On the other hand, the low current ratio indicates that a firm cannot pay its obligation in time as and when it becomes due. It shows the liquidity position of the concern is unsatisfactory. Otherwise, the rule of thumb is 2:1 which means current assets should be double current liabilities.
For an example:-
Current assets of the company are $2,50,000 and current liabilities as $ 1,00,000; current ratio will be calculated as follow;
Current ratio = Current Assets / Current Liabilities
= 2500000/100000 = 2.5:1
The current ratio of the company is 2.5 means that the company’s current assets are 2.5 times of liabilities. It means the company’s liquidity position is satisfactory, and it can meet its current liabilities in time and when it becomes due.
The quick ratio is also called the liquid or Acid test ratio. The quick ratio represents the relationship between quick assets and current liabilities.
Quick assets mean those assets that can convert into cash within a short period without loss of value.
|Quick Ratio = Quick Assets / Current liabilities|
Quick Assets= Current assets – (Inventory + prepaid expenses)*Inventory means all types of stock i.e. Finished, work in progress and raw material
As a rule of thumb, 1:1 is considered the most satisfactory position of quick ratio.
The information is given XYZ Ltd as such
Sundry creditorsBills payable
DebenturesPlant and machinery
|Stock in trade |
Sundry debtorsCash in hand
Cash at bankShort term investment
Marketable securitiesPrepaid insurance
Quick ratio = Quick assets / current liabilities
Quick assets = $220000+ $15000+$ 110000
Current liabilities = $ 150000+ $30000
Quick Ratio= 345000/180000
Quick ratio = 1.916:1
The quick ratio of 1.96 is a satisfactory ratio. It shows that a firm can meet its current or liquid liabilities in time and when they become due.
Absolute liquid assets
Absolute liquid assets included cash in hand and cash at bank and marketable securities. The rule of thumb for this ratio is that 0.5:1 is considered satisfactory.
|Absolute liquid ratio= Absolute Liquid assets / Current liabilities |
Absolute liquid assets = Cash & Bank + short term securities
Example: – The continue the above example of XYZ Ltd Company calculates the absolute liquid ratio
Absolute liquid ratio= Absolute Liquid assets / Current liabilities
Absolute liquid assets = Cash & Bank + Short term securities
=$15000+$110000+ $100000 =$225000
Current liabilities =$ 150000+ $30000 = $ 180000
Absolute liquid ratio = 225000/180000 =1.25:1
The ratio of 1.25 is entirely satisfactory because it is much higher than the rule of thumb, i.e. 0.5.
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