1. What is liquidity ratio?
It’s a ratio which tells one’s ability to pay off its debt as and when they become due. In other words, we can say this ratio tells how quickly a company can convert its current assets into cash so that it can pay off its liability on a timely basis. Generally, Liquidity and short-term solvency are used together.
2. Why Liquidity ratio?
Liquidity ratio affects the credibility of the company as well as the credit rating of the company. If there are continuous defaults in repayment of a short-term liability then this will lead to bankruptcy. Hence this ratio plays important role in the financial stability of any company and credit ratings.
Under liquidity ratio there are several more ratios, which come into the picture for checking how financially, sound a company is:
I. Current Ratio
II. Acid Test Ratio or Quick Ratio
III. Absolute Liquidity Ratio
IV. Basic Defense Ratio
I. Current Ratio
This ratio measures the financial strength of the company. Generally 2:1 is treated as the ideal ratio, but it depends on industry to industry.
Formula: Current Assets/ Current Liability
A. Current Assets = Stock, Debtor, Cash and bank, receivables, loan and advances, and other current assets.
B. Current Liability = Creditor, Short-term loan, bank overdraft, outstanding expenses, and other current liability
II. Acid Test Ratio or Quick Ratio:
This ratio is the best measure of the liquidity in the company. This ratio is more conservative than the current ratio. The quick asset is computed by adjusting current assets to eliminate those assets which are not in cash. Generally 1:1 is treated as an ideal ratio.
Formula: Quick Assets/ Current Liability
Quick Assets = Current Assets – Inventory – Prepaid Expenses
III. Absolute liquidity ratio:
This ratio measures the total liquidity available to the company. This ratio only considers marketable securities and cash available to the company. This ratio only tests short-term liquidity in terms of cash, marketable securities, and current investment.
Formula: Cash + Marketable Securities / Current Liability
IV. Basic Defense Ratio:
This ratio measures the no. of days a company can cover its Cash expenses without the help of additional financing from other sources.
Formula: (Cash + Receivables + Marketable Securities) ÷ (Operating expenses +Interest + Taxes) ÷ 365
|Cash and Cash Equivalent||2188|
|Other Current Assets||254|
|Total Current Assets||11917|
|Income Tax Payable||227|
|Other Outstanding Expenses||1134|
|Total Current Liability||8035|