Ratio Analysis: Liquidity Ratio

Liquidity refers to the ability of a firm to meet its short term liabilities. The liquidity ratio is to measure the ability of the firms to meet their short-term maturing obligations. The greater the coverage of current assets to short-term liabilities shows  a clear signal that a company can pay its debts that are falling due in the coming near future and  ability to  fund its current operations. A low coverage rate  raises a red flag for investors  and they  may think that the company will have difficulty in  meeting the  running  operations and its obligations. Current Ratio & Liquid Ratio are the part of  the Liquidity Ratio.

Current Ratio= Current Assets/Current Liabilities

Current assets includes cash, Bank, Stock, Debtors, Bills Receivables, Short Term Investment, Prepaid expenses, Short Term loan & Advances given , Marketable Securities, Accrued Income etc. Whereas Current liabilities includes Sundry Creditors, Bills payable,  Outstanding expenses, Short term provision, Dividend payable , Provision for taxation,  provision for doubtful debts, Advance receipts, current maturities of long term debt etc.

Current Ratio indicates the number of times that the short term assets can cover the short term debts.  Higher the ratio, the better it is, however but too high ratio reflects an in-efficient use of resources & too low ratio leads to insolvency. The ideal ratio is considered to be 2:1.

Quick ratio= Liquid Asset/Current Liabilities

Liquid assets = Current Assets – Prepaid Expenses – Inventories (Stock)

Acid test ratio is its another name. Indicates the ability to meet short term payments using the most liquid assets. This ratio is more conservative than the current ratio because it excludes inventory and prepaid expenses.The ideal ratio is  considered 1:1.

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