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What is Liquidity Ratio? Know the Types, Formula and Calculation

IndianMoney.com Research Team | Posted On Wednesday, January 15,2020, 04:30 PM

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What is Liquidity Ratio? Know the Types, Formula and Calculation

 

 

What is Liquidity Ratio?

In simple words, the liquidity ratio measures a company’s liquidity. Liquidity is the availability of cash or cash equivalents to meet the short term obligations of the business.

Definition: Liquidity ratio can be defined as a means to determine a company’s ability to repay outstanding debts when they are due. It is a measure of the company’s potential to meet its short term obligations.

Lenders and creditors make decisions regarding lending, based on liquidity ratios. Therefore, liquidity ratio affects an organization’s credibility. Want to know more on Investment Planning? We at IndianMoney.com will make it easy for you. Just give us a missed call on 022 6181 6111 to explore our unique Free Advisory Service. IndianMoney.com is not a seller of any financial products. We only provide FREE financial advice/education to ensure that you are not misguided while buying any kind of financial product.

What is Liquidity Ratio? Know The Types, Formula, and Calculation

Types of Liquidity Ratios

There are many types of liquidity ratios. Let us take a brief look at some of them.

See Also: Statutory Liquidity Ratio - Everything you Need to Know

1. Current Ratio: It is the most commonly used liquidity ratio. It is a ratio between the current assets and current liabilities of a firm. It measures if the current assets of the firm can pay off the current liabilities (debts), considering a margin of safety that covers potential losses during the realization of assets.

The ideal current ratio is 2:1. This is a subjective figure. It depends on the nature of the business.

Where,

Current assets = sundry debtors + inventories + cash-in-hand + cash-at-bank + receivables + loans and advances + disposable investments + advance tax.

Current liabilities = creditors + short term loans + bank overdraft + cash credit + outstanding expenses + provision for taxation + dividend payable.

See Also: What Happens When Cash Reserve Ratio Increases?

2. Quick Ratio: It is also known as the acid-test ratio. It is the relationship between the quick assets (current assets – inventory) and current liabilities of a firm. Quick assets mean assets that can be readily converted to cash. It does not include inventories as they are not easily convertible to cash. It also excludes prepaid expenses. The ideal quick ratio is 1:1.

                                                 

Where,

Quick assets = current assets – inventories – prepaid expenses.

3. Cash Ratio: It is a means to measure the absolute liquidity of a firm. It checks if a firms’ cash balance, bank balance and marketable securities can be utilized to pay off the current debt. Inventory and debtors are consciously excluded because of the uncertainty involved in their realization.

4. Net working capital ratio: It is a means to measure the cash flow. Ideally net working capital ratio must be positive. This is often used by banks to check if there is potential for a financial crisis.

5. Interest Coverage Ratio: It determines a company’s ability to pay off interest on outstanding debt. It is calculated for a particular period, considering the interest due for that period. A higher coverage ratio is considered ideal, though it can vary with industry.

Why Liquidity Ratio is Important?

The liquidity ratio is significant because it has a number of advantages. A few of them are:

  • Give an understanding on the company’s liquidity.
  • It projects management efficiency.
  • Gives an idea on the company’s operating cycle.
  • Serves as an information tool to lenders and creditors.
  • The different type of ratios can be utilized in various situations.
  • It helps companies take necessary steps as and when necessary.

See Also: Saving Account vs. Liquid Funds: Which Gives Better Returns

Good Liquidity Ratio

A good liquidity ratio is any value greater than or equal to 1. It indicates that the company is in good financial health and is less prone to facing financial hardships.  As the liquidity ratio increases, it is an indication on the extent of the safety margin a company possesses to meet its current debts.

See Also: Debt Funds vs. Liquid Funds: Which One Should I Invest?

Liquidity Ratio Analysis with Examples:

Here we will see how to analyze liquidity ratios:

Current ratio:

 

Rs

 

Rs

Sundry creditors

15,000

Cash

10,000

Outstanding expenses

2,000

Short term investments

20,000

Bills payable

8,000

Bills receivables

6,000

Income tax payable

10,000

inventories

44,000

Bank overdraft

35,000

Prepaid expenses

5000

 

 

 

 

total

70,000

total

85,000

Total current assets =  Rs 85,000

Total current liabilities =  Rs 70,000

Current ratio = 85,000/ 70,000= 1.214

Interpretation: For every rupee worth of current liabilities, there are current assets worth Rs 1.21. A high current ratio indicates that the company has excess assets to meet its liabilities. 

Limitations: It fails to measure the liquidity of individual components of assets. For example, an organization may have a high current ratio because of inventory. But this inventory cannot be easily converted to cash. So current ratio can be misguiding.

Quick ratio

 

Rs

 

Rs

Sundry creditors

15,000

Cash

10,000

Outstanding expenses

2,000

Short term investments

20,000

Bills payable

8,000

Bills receivables

6,000

Income tax payable

10,000

inventories

44,000

Bank overdraft

35,000

Prepaid expenses

5000

 

 

 

 

Total

70,000

Total

85,000

Quick assets= current assets - inventories-prepaid expenses = Rs 36,000

Quick ratio = 36,000/70,000=0.514

Interpretation: Here the quick ratio is less than one. This indicates that the firm does not have enough quick assets to meet the short debts. A firm with a lower quick ratio may not be opted for by creditors.

Limitation: Although excluding inventories can be beneficial in many cases, in some industries it can be a disadvantage. The supermarket industry has a huge inventory purchased via credit. In such cases, the liabilities would be higher than assets. The time frame of payments is not taken into consideration.

See Also: Important Credit Control Tools Of RBI: CRR, Repo and Reverse Repo Rates

Cash Ratio

Cash = Rs 10,000

Cash equivalents= Rs 5,000

Accounts payable= Rs7000

Current tax payable= Rs 1,000

 Cash ratio = (10000+5000)/(1000+7000)=1.875

Interpretation: In this example, the firm has a high cash ratio. This means the firm maintains a high cash balance.

Conclusion:

Hence, with the above-given data, you will be in a position to realize that liquidity ratios are significant. It helps to understand the financial strength of a firm. This is utilized by banks, investors, creditors and the company itself.

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