What are liquidity ratios?
Discuss the importance of current and liquid ratio.
Discuss the importance of current and liquid ratio.
Liquidity ratios are calculated to determine the short-term solvency of the business. Analysis of current position of liquid funds determines the ability of the business to pay the amount due as per commitment to stakeholders. Included in this category are current ratio and quick ratio.
Current Ratio/Working Capital Ratio:
This ratio establish relationship between current assets and current liabilities. The standard for this ratio is 2 : 1. It means a ratio 2 : 1 is considered favorable. It is calculated by dividing the total of the current assets by total of the current liabilities.
The formula for the current ratio is as follows:
Current Ratio = Current Assets/Current Liabilities
Or
Current Assets : Current Liabilities
Importance of Current Ratio:
Current Ratio povides a measure of degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a measure of safety margin available against uncertainly in realisation of current assets and flow of funds. However, it must be interpreted carefully because window-dressing is possible by manipulating the components of current assets and current liabilities, e.g., it can be manipulated by making payment to creditors. A very high current ratio is not a good sign as it reflects under utilization or improper utilization of resources.
Liquid/Acid Test/ Quick Ratio:
This ratio establishes relationship between quick assets and current liabilities. Quick assets are those assets which can get converted into cash easily in case of emergency. Out of current assets it is believed that stock and prepaid expenses are not possible to convert in cash quickly. The current liabilities they will be considered favourable with the view point of company’s credibility.
The formula for the quick ratio is as follows:
Quick Ratio = Quick Assets/Current Liabilities
Or
Quick Assets = Current Assets – Stock + Prepaid Expenses
Importance of Quick Ratio:
It helps in determining whether a firm has sufficient funds if it has to pay all its current liabilities immediately. Sometimes quick ratio is calculated on the basis of quick liability instead of current liabilities. Quick liabilities are calculated by ignoring bank overdraft, if any. It means to get the figure of quick liabilities from current liabilities; bank overdraft is deducted from current liabilities.
Liquidity ratios are calculated to determine the short-term solvency of the business. Analysis of current position of liquid funds determines the ability of the business to pay the amount due as per commitment to stakeholders. Included in this category are current ratio and quick ratio.
Current Ratio/Working Capital Ratio:
This ratio establish relationship between current assets and current liabilities. The standard for this ratio is 2 : 1. It means a ratio 2 : 1 is considered favorable. It is calculated by dividing the total of the current assets by total of the current liabilities.
The formula for the current ratio is as follows:
Current Ratio = Current Assets/Current Liabilities
Or
Current Assets : Current Liabilities
Importance of Current Ratio:
Current Ratio povides a measure of degree to which current assets cover current liabilities. The excess of current assets over current liabilities provides a measure of safety margin available against uncertainly in realisation of current assets and flow of funds. However, it must be interpreted carefully because window-dressing is possible by manipulating the components of current assets and current liabilities, e.g., it can be manipulated by making payment to creditors. A very high current ratio is not a good sign as it reflects under utilization or improper utilization of resources.
Liquid/Acid Test/ Quick Ratio:
This ratio establishes relationship between quick assets and current liabilities. Quick assets are those assets which can get converted into cash easily in case of emergency. Out of current assets it is believed that stock and prepaid expenses are not possible to convert in cash quickly. The current liabilities they will be considered favourable with the view point of company’s credibility.
The formula for the quick ratio is as follows:
Quick Ratio = Quick Assets/Current Liabilities
Or
Quick Assets = Current Assets – Stock + Prepaid Expenses
Importance of Quick Ratio:
It helps in determining whether a firm has sufficient funds if it has to pay all its current liabilities immediately. Sometimes quick ratio is calculated on the basis of quick liability instead of current liabilities. Quick liabilities are calculated by ignoring bank overdraft, if any. It means to get the figure of quick liabilities from current liabilities; bank overdraft is deducted from current liabilities.
