When it comes to financing, liquidity is a crucial aspect to consider. Liquidity ratio is an essential accounting tool that is used to determine the current debt-repaying ability of a borrower.
Liquidity Ratio is a measure used for determining a company's ability to pay off its short-term liabilities.
This ratio reflects whether an individual or business can pay off short-term dues without any external financial assistance. Considering the liquid assets, present financial obligations are analysed to validate the safety limit of a company.
If the liquidity ratio is higher, it is easier to pay off the debts.
Possessing a substantial amount of liquid assets provides the ability to pay off short-term financial obligations on time. Here are the liquidity ratio types, along with a detailed liquidity ratio formulae–
The current ratio implies the financial capacity of a company to clear off its current obligations by using its current assets.
Here the current assets include cash, stock, receivables, prepaid expenditures, marketable securities, deposits, etc. Current debts include short-term loans, payroll liabilities, outstanding expenses, creditors, various other payables, etc.
Formula:
Current Ratio = Current Assets / Current Liabilities
Any current ratio lower than 1 implies a negative financial performance for that business or individual. A current ratio below one is indicative of one’s inability to pay off the present-time monetary obligations with their assets.
Example of Current Ratio:
Current assets | Current liabilities | Current ratio (current assets / current liabilities) |
Rs. 260 crore | Rs. 130 crore | Rs. 260 crore / Rs. 130 crore = 2:1 |
Quick ratio or acid test ratio is another liquidity ratio that determines a company’s current available liquidity.
Easily convertible (in cash) marketable securities and present holding of cash are considered while calculating the quick ratio. Hence, inventories are excluded when the acid test ratio is concerned.
Formula:
A 1:1 quick ratio is ideal and reflects the stable financial position of a company.
Example of Quick Ratio:
Particulars of current assets | Amount in crore | |
Cash and equivalent | Rs. 65,000 | |
Marketable securities | Rs. 15,000 | |
Accounts receivables | Rs. 35,000 | |
Inventory | Rs. 45,000 | |
Total current assets | Rs. 160,000 | |
Total current liabilities | Rs. 60,000 | |
Current Ratio | As per formula 1 = (Rs. 65,000 + Rs. 15,000 + Rs. 35,000)/ Rs. 60,000
= Rs. 115,000/Rs. 60,000 = 1.91 As per formula 2 = (Rs. 160,000 – Rs. 45,000)/Rs. 60,000 = Rs. 115,000/Rs. 60,000 = 1.91 |
The cash or equivalent ratio measures a company’s most liquid assets, such as cash and cash equivalent to the entire current liability of the concerned company.
As money is the most liquid form of assets, this ratio indicates how quickly and to what limit a company can repay its current dues with the help of its readily available assets.
Formula:
Cash Ratio = Cash and Equivalent / Current liabilities
The absolute liquidity ratio pits marketable securities, cash and equivalents against current liabilities. Businesses should strive for an absolute liquidity ratio of 0.5 or above.
Formula:
Absolute Liquidity Ratio = (Cash and Equivalent + Marketable Securities)/Current Liabilities
Example of Absolute Liquidity Ratio:
Particulars of liquid assets | Amount in crore | |
Cash and equivalent | Rs. 1,65,000 | |
Marketable securities | Rs. 75,000 | |
Accounts receivables | Rs. 90,000 | |
Inventory | Rs. 1,00,000 | |
Current liquid assets | Rs. 4,30,000 | |
Particular of Current liabilities | Amount | |
Bills payables | Rs. 90,000 | |
Bank overdraft | Rs. 80,000 | |
Outstanding expenses | Rs. 30,000 | |
Creditors | Rs. 1,00,000 | |
Total current liabilities | Rs. 3,00,000 | |
Absolute liquidity ratio | (Rs. 1,65,000 + Rs. 75,000)/Rs. 3,00,000
= Rs. 2,40,000/Rs. 3,00,000 =0.8 |
The basic defence ratio is an accounting metric that determines how many days a company can run on its cash expenses without any outside financial aid. It is also called the defensive interval period and basic defence interval.
Formula:
Basic Defence Ratio = Current Assets/Daily Operational Expenses
Current Assets = Marketable Securities + Cash and Equivalent + Receivables
Daily Operational Expenses = (Annual Operational Costs – Non-cash Expenses)/365
Example of a Basic Defence Ratio:
Particulars of liquid assets | Amount in crore | |
Cash and equivalent | Rs. 1,05,000 | |
Marketable securities | Rs. 55,000 | |
Accounts receivables | Rs. 80,000 | |
Current liquid assets | Rs. 2,40,000 | |
Particular of daily operational expenses | Amount | |
Annual operating cost | Rs. 5,00,000 | |
Non-cash expenses | Rs. 70,000 | |
Daily operational expenses | Rs. 4,30,000/365 = 1178 | |
Basic defence ratio | Rs. 2,40,000/1178
= 203 |
Contrary to the above-stated ratios, the basic liquidity ratio is not related to the company’s financial position. Instead, it is an individual’s financial ratio that denotes a timeline for how long a family can finance its needs with its liquid assets. A minimum of 3 months of monetary backup is desirable.
Formula:
Basic Liquidity Ratio = Monetary Assets / Monthly Expenses
As a useful financial metric, the liquidity ratio helps to understand the financial position of a company.