Log In Sign Up
FREE software to file tax return of your clients
Enter all client details with a single XML upload

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.

3. Formulas

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

Where,

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

Where,

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

Example:

Particulars Amount
Cash and Cash Equivalent 2188
Short-Term Investment 65
Receivables 1072
Stock 8338
Other Current Assets 254
Total Current Assets 11917
Accounts Payable 4560
Outstanding Expenses 809
Taxes Payable 307
Deferred Revenue 998
Income Tax Payable 227
Other Outstanding Expenses 1134
Total Current Liability 8035

 

Additional Details:

  1. Operating Expenses during the year is 2188
  2. Net Interest paid during the year is 25
  3. Taxes paid/ for the year is 1913
  4. Current Ratio = Current Assets/Current Liability                                                                   = 11971 ÷8035   = 1.48
  5. Quick Ratio = (Current Assets- Inventory)/Current Liability                                         = (11971-8338)÷8035    = 0.45
  6. Basic Defense Interval = (Cash + Receivables + Marketable            Securities) ÷ (Operating expenses +Interest + Taxes)÷365                                                                 = (2188+1072+65)÷(11215+25+1913)÷365                                                     = 92.27
  7.  Absolute liquidity ratio=(Cash + Marketable Securities)÷Current                                                        Liability 

=(2188+65) ÷ 8035                                                                                                 = 0.28

FREE software to e-file tax return of your clients
Signup Now for FREE