Liquid Ratio, a type of liquidity ratio, may be defined as the relationship between quick or liquid assets and current liabilities. An asset is said to be liquid if can be converted into cash within a short period without loss of value. This ratio is also known as Quick ratio or Acid test ratio. This ratio is the more rigorous test of liquidity that the current ratio. The interpretation of this ratio is made with reference to current assets excluding prepaid expenses and inventories i.e. liquid assets and current liabilities. This ratio is calculated as follows:
Liquid Ratio= Liquid Assets/ Current Liabilities.
EXAMPLE: Suppose the liquid assets of a concern as Rs. 2,50,000 and current liabilities of the concern are Rs. 1,00,000. The current ratio will be calculated as follows:
Liquid ratio= Liquid Assets/ Current Liabilities
LIQUID ASSETS: Liquid assets are the assets that can be easily converted into cash. These assets include the following assets:
- Cash in hand
- Cash at bank
- Bills receivables
- Sundry debtors
- Marketable securities
- Temporary investments
Assets not included in liquid assets are:
- Prepaid expenses
These can be calculated as:
Liquid Assets= Current Assets- Prepaid expenses- Inventories
CURRENT LIABILITIES: Current liabilities are the liabilities payable within 12 months from the date of balance sheet or within the period of operating cycle. Current liabilities include the following liabilities:
- Short term borrowings
- Trade payables i.e. creditors and bills payable
- Short term provisions
- Outstanding expenses
- Incomes received in advance, etc.
LIQUID RATIO INTERPRETATION
A high liquid or quick ratio is an indication that the firm is liquid and has the ability to meet its current or liquid liabilities. The high liquid ratio is bad when the firm is having slow-paying debtors.
On the other hand, a low quick ratio represents that the firm’s liquidity position is not good. The low liquid or quick ratio may be considered satisfactory if it has fast moving inventories.
IDEAL LIQUID RATIO
The ideal liquid or quick ratio is 1:1. It means the current assets should be equal to the current liabilities only then the firm will be able to meet its short term obligations. Although the quick ratio is more rigorous test of liquidity than current ratio, yet it should be used cautiously and rule 1:1 should not be used blindly. A quick ratio of 1:1 does not necessarily mean satisfactory liquidity position if all the debtors cannot be realized and cash is needed immediately to meet the current obligations of the firm.
SIGNIFICANCE OF LIQUID RATIO
The quick ratio is very useful in measuring the liquidity position of a firm. It measures the firm’s capacity to pay off current obligations immediately and is a more rigorous test of liquidity than the current ratio. It is used as a complementary ratio to the current ratio.