Liquidity Ratios

Liquidity ratios assess a firm's ability to meet its short-term obligations. These ratios compare current assets and current liabilities, revealing how quickly a firm can convert assets to cash to pay off debts due within a year. Key liquidity ratios include the Current Ratio, Quick Ratio, and Absolute Cash Ratio.

Current Ratio

Definition: The Current Ratio, or working capital ratio, measures the relationship between current assets and current liabilities. It indicates a firm's ability to cover short-term liabilities with its short-term assets.

Formula:

Current Ratio = $\frac{C u r r e n t A s s e t s}{C u r r e n t L i a b i l i t i e s}$

Components:

Current Assets: Stock, debtors, cash and bank balances, bills receivable, accruals, short-term loans given, short-term securities.
Current Liabilities: Creditors, outstanding expenses, short-term loans taken, bank overdrafts, provision for taxation, proposed dividends.

Significance:

An ideal current ratio is 2:1, meaning the firm should have twice the current assets as current liabilities.
A very high ratio may indicate underutilized assets, while a low ratio suggests potential liquidity problems.

Quick Ratio

Definition: The Quick Ratio, also known as the acid test ratio, measures a firm's ability to pay off current liabilities with its most liquid assets, excluding inventory and prepaid expenses.

Formula:

Quick Ratio = $\frac{Q u i c k A s s e t s}{C u r r e n t L i a b i l i t i e s - Q u i c k L i a b i l i t i e s}$

Components:

Quick Assets: Current assets excluding stock and prepaid expenses (cash, cash equivalents, marketable securities).
Quick Liabilities: Current liabilities excluding bank overdraft and cash credit.

Significance:

The ideal quick ratio is 1:1, indicating that the firm can meet its short-term obligations without liquidity problems.
It provides a more stringent test of liquidity than the current ratio as it excludes less liquid assets like inventory.

Absolute Cash Ratio

Definition: The Absolute Cash Ratio is a stringent liquidity measure, focusing only on the availability of cash and cash equivalents to meet short-term liabilities.

Formula:

Absolute Cash Ratio = $\frac{C a s h + B a n k B a l a n c e + M a r k e t a b l e S e c u r i t i e s}{C u r r e n t L i a b i l i t i e s}$

Components:

Cash: Actual cash in hand.
Bank Balance: Cash held in bank accounts.
Marketable Securities: Highly liquid investments that can be quickly converted into cash.

Significance:

This ratio shows the firm’s immediate cash availability to meet short-term obligations.
There is no ideal ratio, but a ratio greater than 1 may indicate poor resource management and excessive liquidity, which could lead to lower profitability.

Summary

Liquidity ratios are crucial for assessing a firm's short-term financial health. They help determine if the company can meet its immediate obligations without compromising its operations. The Current Ratio provides a general overview, the Quick Ratio offers a more precise test by excluding less liquid assets, and the Absolute Cash Ratio focuses on immediate cash availability. Together, these ratios help management and investors understand and improve the firm's liquidity position.

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Liquidity Ratios