LIQUIDITY RATIOS
The liquidity ratios are used to assess the short term financial position of the firm. Liquidity refers to the ability of the firm to meet its current liabilities. That is why these ratios are also known as ‘short-term solvency ratios’. These ratios indicate the firm’s ability to meet its current obligations out of current resources.
ACCORDING TO SALOMAN J FLINK
“Liquidity is the ability of the firm to meet its current obligation as they fall due.
ACCORDING TO HERBERT B MAYO
“Liquidity is the ease with which assets may be converted into cash without loss.”
TYPES OF LIQUIDITY RATIOS
The various liquidity ratios are as follows:
CURRENT RATIO
Current ratio explains the relationship between current assets and current liabilities. This ratio is also known as working capital ratio. This ratio is a measure of general liquidity and is most likely to make the analysis of the short term financial position or liquidity position of the firm. It is calculated by dividing the current assets with the current liabilities.
CURRENT RATIO= Current Assets/ Current Liabilities
EXAMPLE: Suppose the current 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:
Current ratio= Current Assets/ Current Liabilities
Current ratio= 2,50,000/1,00,000
Current Ratio= 2.5:1.
CURRENT ASSETS
Current assets are the assets which are likely to be converted into cash or cash equivalents within 12 months from the date of balance sheet or within the period of operating cycle. Current assets include the following assets:
- Current investments
- Stock or inventories
- Trade receivables i.e. debtors and bills receivables.
- Short term loans and advances
- Cash in hand
- Cash at bank
- Prepaid expenses
- Accrued incomes, etc.
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 includes the following liabilities:
- Short term borrowings
- Trade payables i.e. creditors and bills payable
- Short term provisions
- Outstanding expenses
- Incomes received in advance, etc.
INTERPRETATION OF THE RATIO
A relatively high current ratio is an indication that the firm is liquid and has the ability to pay its current obligations in time as and when they become due. The high current ratio may not be favorable due to the following reasons:
- There may be slow moving stocks. The stocks will be pile up due to poor sale.
- The figures of debtors may go up because debt collection is not satisfactory.
- The cash or bank balances may be lying idle because of insufficient investments opportunities.
A relatively low current ratio represents that the liquidity position of the firm is not good and the firm shall not be very able to pay its current liabilities in time without facing difficulties. A low current ratio may be not favorable due to the following reasons:
- There may not be sufficient funds to pay off liabilities.
- There business may be trading beyond its capacity. The resources may not warrant the activities.
IDEAL CURRENT RATIO
The ideal current ratio is considered in the ratio of 2:1 i.e. current assets double the current liabilities is considered to be satisfactory. The idea of having double the current assets as compared to current liabilities is to provide for delays and losses in the realization of current assets.
FACTORS TO BE CONSIDERED WHILE USING CURRENT RATIO
A number of factors should be taken into consideration before reaching the conclusion about short-term financial position. Some of these factors are as follows:
TYPE OF BUSINESS: Current ratio is influenced by the type of business. A business with heavy investments in fixed assets may be successful even if the ratio is low. On the other hand, a trading concern will require a high current ratio because it has to pay its suppliers quickly.
TYPES OF PRODUCTS: The type of products in which a business deals also influences current ratio. A business dealing in goods whose demand changes fast will require a higher current ratio. On the other hand, if products have more intrinsic value such as gold, silver, metals etc. a lower current ratio may also do.
REPUTATION OF THE CONCERN: A business unit with better goodwill and reputation may afford a small current ratio because the turnover is more and creditors also allow credit for longer periods. A new concern or a concern which has not established its reputation will need higher current assets to pay current liabilities in time.
SEASONAL INFLUENCE: Current assets and current liabilities change with the seasons. In a peak season, current assets will be more and current ratio will be high. On the other hand this ratio will go down when the season is off.
TYPE OF ASSETS AVAILABLE: This type of current assets in the business also influences interpretation of current ratio. If the current assets include large amounts of slow moving stocks then even a high ratio may not be satisfactory.
All the above mentioned factors should be taken into mind while interpreting current ratio.
OBJECTIVE AND SIGNIFICANCE OF CURRENT RATIO
Current ratio is a general and quick measure of liquidity of a firm. It represents the ‘margin of safety’ or ‘cushion’ available to the creditors and other current liabilities. It is most widely used for making short-term analysis of the financial position or short-term solvency of the firm.
LIMITATIONS OF CURRENT RATIO
The following are the limitations of the current ratio are as follows:
CRUDE RATIO: It is a crude ratio because it measures only the quantity and not the quality of current assets.
WINDOW DRESSING: The valuation of current assets and window dressing is another problem if current ratio. Current assets and liabilities are manipulated in such a way that current ratio loses its significance. Window dressing may be indulged in the following ways:
- Over valuation of a closing stock.
- Obsolete or worthless stocks are shown in the closing inventory at their costs instead of writing them off.
- Recording in advance cash receipts applicable to the next year’s sales.
- Omission of a liability for merchandise included in inventory.
- Treating a short-term obligation as a long-term liability.
- Inadequate provision for bad and doubtful debts.
- Inclusion in debtors advance payment for purchase of fixed assets.
Window dressing is done to show current ratio at a particular figure. It does not present the real financial position of the concern. The inferences drawn on such a will be faulty and deceptive.
LIQUID RATIO
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. The liquid 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 liquid ratio interpretation is made with reference to current assets excluding prepaid expenses and inventories i.e. liquid assets and current liabilities. The liquid 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 ratio= 2,50,000/1,00,000
Liquid Ratio= 2.5:1.
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
- Inventories.
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 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 liquid ratio represents that the firm’s liquidity position is not good. The low liquid ratio may be considered satisfactory if it has fast moving inventories.
IDEAL LIQUID RATIO
The ideal liquid 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 liquid 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 liquid 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 liquid 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.
ABSOLUTE LIQUID RATIO
Absolute Liquid Ratio is a type of liquidity ratio that is calculated to analyze the short term solvency or financial position of the firm. It is calculated to exclude the receivables from the current and liquid assets and to know about the absolute liquid assets. Although receivables, debtors and bills receivables are generally more liquid than inventories, yet there may be doubts regarding their realization into cash immediately or on time as there are the chances of bad debts. To exclude this possibility, absolute ratio is calculated. The absolute liquid ratio is also known as Cash ratio. The absolute liquid ratio formula is:
Absolute Liquid Ratio= Absolute Liquid Assets/ Current Liabilities
ABSOLUTE LIQUID ASSETS: The assets included in absolute liquid assets are as follows:
- Cash in Hand: Cash in hand means the cash available with the business house at a point of time.
- Cash at Bank: Cash at bank means the cash that is with the business by the way of deposits in the bank accounts may it be saving account, current account or any kind of other account.
- Marketable Securities: Marketable Securities are those securities that can be readily converted in to the cash by sale. These are generally traded in the money market. These securities are also known as temporary investments.
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: Short term borrowings are those borrowings that the business house has to repay within 12 months or a year. These borrowings may be secured or unsecured.
- Trade payables i.e. creditors and bills payable: Trade Payables includes the creditors or bills payable. Creditors are the persons from whom the business purchases the goods on credit and make guarantee to repay their payment on some future date.
- Short term provisions: The provisions like provision for doubtful debts, provisions for repairs, provision for taxation are short term provisions. These made to meet any short term liability that might arise in the future.
- Outstanding expenses: The expenses which have become due but are not paid yet are Outstanding Expenses. Example of these expenses is: Salary due but not paid, Electricity bill due but not paid, etc.
- Incomes received in advance: The incomes received in advance makes the business house liable to perform the contract.
IDEAL ABSOLUTE LIQUID RATIO
The ideal standard for this ratio is 0.5:1 i.e. 50%. This means Rs. 1 worth absolute liquid assets are considered adequate to pay Rs. 2 worth current liabilities in time as all the creditors are not expected to demand cash at the same time and then cash may also be realized from debtors and inventories.
EXAMPLE: Suppose the firm has following assets and liabilities:
| Goodwill | 50,000 | Cash at bank | 30,000 |
| Plant and machinery | 4,00,000 | Inventories | 75,000 |
| Trade investments | 2,00,000 | Bank overdraft | 70,000 |
| Marketable securities | 1,50,000 | Sundry creditors | 60,000 |
| Bills receivables | 40,000 | Bills payable | 90,000 |
| Cash in hand | 45,000 | Outstanding expenses | 30,000 |
Absolute Liquid Ratio= Absolute Liquid Assets/ Current Liabilities
Absolute liquid assets= marketable securities+ cash in hand+ cash at bank
=1,50,000+ 45,000+ 30,000
=2,25,000
Current Liabilities= Bank Overdraft+ Sundry Creditors + Bills payable+ Outstanding expenses
= 70,000+ 60,000+ 90,000+30,000
= 2,50,000
Absolute liquid ratio= 2,25,000/ 2,50,000
= 0.9.