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When it comes to financing, liquidity is a crucial aspect to consider. And liquidity ratio is an essential accounting tool that is used to determine the current debt repaying ability of a borrower. Simply, this ratio reflects whether an individual or business can pay off the 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.

Types of Liquidity Ratios

Possessing a substantial amount of liquid assets provides the ability to pay off short-term financial obligations on time. Here are the available liquidity ratio types

  • Current ratio

Current ratio implies the financial capacity of a company to clear off the current obligations by using its current assets. Here the current assets include cash, stock, receivables, prepaid expenditures, marketable securities, deposits, etc. And, 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 assetsCurrent liabilitiesCurrent ratio (current assets / current liabilities)
Rs. 260 croreRs. 130 croreRs. 260 crore / Rs. 130 crore = 2:1
  • Quick ratio or Acid test ratio

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 acid test ratio is concerned.

Formula:

  1. Quick ratio = (marketable securities + available cash and/or equivalent of cash + accounts receivable) / current liabilities
  2. Quick ratio = (current assets – inventory) / current liabilities

1:1 quick ratio is ideal and reflects a stable financial position of a company.

Example of quick ratio:

Particulars of current assetsAmount in crore
Cash and equivalentRs. 65,000
Marketable securitiesRs. 15,000
Accounts receivablesRs. 35,000
InventoryRs. 45,000
Total current assetsRs. 160,000
Total current liabilitiesRs. 60,000
Current ratioAs 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

  • Cash ratio

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

  1. Absolute liquidity ratio

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 assetsAmount in crore
Cash and equivalentRs. 1,65,000
Marketable securitiesRs. 75,000
Accounts receivablesRs. 90,000
InventoryRs. 1,00,000
Current liquid assetsRs. 4,30,000
Particular of Current liabilitiesAmount
Bills payablesRs. 90,000
Bank overdraftRs. 80,000
Outstanding expensesRs. 30,000
CreditorsRs. 1,00,000
Total current liabilitiesRs. 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

  1. Basic defence ratio

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 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 assetsAmount in crore
Cash and equivalentRs. 1,05,000
Marketable securitiesRs. 55,000
Accounts receivablesRs. 80,000
Current liquid assetsRs. 2,40,000
Particular of daily operational expensesAmount
Annual operating costRs. 5,00,000
Non-cash expensesRs. 70,000
Daily operational expensesRs. 4,30,000/365 = 1178
Basic defence ratioRs. 2,40,000/1178

= 203

6. Basic liquidity ratio

Contrary to the all above-stated ratios, basic liquidity ratio is not related to company’s financial position. Instead, it is an individual’s financial ratio that denotes a timeline for how long a family can finance its need with its liquid assets. A minimum of 3 months monetary back up is desirable.

Formula:

Basic liquidity ratio = Monetary assets / monthly expenses

Importance of Liquidity Ratio

As a useful financial metric, liquidity ratio helps to understand the financial position of a company.

  • Liquidity ratio helps to understand the cash richness of a company. It also helps to perceive the short-term financial position. A higher ratio implies the stability of the company. Contrarily, poor ratio carries a risk of monetary damages.
  • This ratio provides the complete idea of the concerned company operating system. It depicts how effectively and efficiently the company sells its product or services to convert the inventories into cash. With the help of this ratio, a company can improve the production system, plan better inventory storage to avoid any loss and prepare effective overhead expenses.
  • A company’s financial stability also depends on its management. Hence, considering this ratio, a company can also optimise its management efficiency in following the demands of potential creditors.
  • With the help of this ratio, company management can also work towards betterment of its working capital requirements.

Limitations of Liquid Ratio

  • Similar to the number of liquid assets, quality also plays a crucial part. This ratio only considers the amount of a company’s current assets. Thus, it is advisable to consider other accounting metrics along with liquidity ratio to analyse a company’s liquid strength.
  • Liquidity ratio involves inventory to calculate a company’s liquidity. However, this can lead to a miscalculation due to overestimation. Higher inventory can also be a reason for fewer sales. Hence, inventory calculation might not provide the real liquidity of a company.
  • This ratio might also be an outcome of creative accounting, as it only includes the balance sheet information. To understand the financial position of an organisation, analysts must go beyond the data on the balance sheet to perform liquidity ratio analysis.

FAQs

  • What is the difference between solvency and liquidity? 

Liquidity stands for the money that covers the short term financial obligation of a company. Contrarily, solvency implies an organisation’s ability to pay off the total debt while continuing the business operations. Liquidity ratio is an essential part to account solvency of a company.

  • What is the ideal current ratio?

If the current ratio is more than 1, then it is considered as ideal. Higher current ratio indicates the better liquid position of a company.

  • What is considered as SLR?

Government securities such as bonds, cash and gold, are considered as the assets to maintain SLR or Statutory Liquidity Ratio, as per the RBI guidelines.

  • What is the most liquid asset?

Cash is the most liquid asset in the world. A higher amount of cash holding indicates higher liquidity ratio of a company. That means the concerned company is prepared to meet any short term financial obligation without any outside financial support.

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