Liquidity(Current and Liquid) Ratio with Interpretations.

Liquidity Refers to the ability of a firm to meet the short term obligations/requirements as and when they arise.  Various liquidity ratios are available that measure the short term solvency or financial position of a firm.  These ratios are usually calculated to determine the short term paying of a concern or its ability to meet the current obligations. The various liquidity ratios are.


(a) Current Ratio
Current Ratio[Current Assets/Current Liabilities] is defines as the ratio/relationship between current assets and current liabilities.  Current Ratio is also called as 'Working Capital Ratio'.


Formula: 







Components: The Two major Components of current ratio are Current Assets and Current Liabilities.  
Current Assets include 
Cash in hand, 
Cash at bank, 
Short-term marketable securities, 
Short-term Investments, 
Bills receivable, 
Sundry Debtors, 
Inventories/Stocks, 
Work-In-Progress, 
Prepaid Expenses. 


Current Liabilities include 
Outstanding/accrued Expenses, 
Bills Payable, 
Sundry Creditors, 
Short-term Advances, 
Income-Tax Payable, 
Dividends payable, 
Bank Overdraft. 


Interpretation: Current Ratio indicates the amount of current assets owned by a firm for each current liability.  While interpreting the current ratio a standard [Ideal Ratio: 2:1] called as arbitrary standard of liquidity or banker's rule of thumb is considered.  If the result of the current ratio is greater than or equal to 2, then the firm is said to possess many current assets than its current liabilities, indicating good liquidity position of the firm. 

Significance: Current Ratio measured the Ability of the firm in meeting short term obligations.  Higher the ratio, greater the margin of safety to the ratio of creditors.  It also provides the ratio of the current assets and current liabilities. 

 (b) Liquid Ratio.
Liquid Ratio[(Current Assets - Inventory/Stock)/Current Liabilities] is defined as the ratio/relationship between the quick/liquid assets and current/liquid liabilities.  Liquid ratio is also called Quick Ratio or Acid Test Ratio.


Formula:



Components:  Liquid Ratio consists of two components, liquid assets and current liabilities.  Liquid assets are obtained by excluding stock from current assets.


Interpretation: While interpreting the Quick/Liquid Ratio, a standard [Ideal Ratio: 1:1] is taken as a rule of thumb.  A high liquid ratio indicates that the firm is liquid and has enough liquid assets to meet the liquid liabilities on time.

Significance: The quick ratio plays a vital role in measuring the liquidity position of a firm.  It measured the capacity of the firm to meet the current obligations  It is a more rigorous test of liquidity than the current ratio. A liquid ratio is usually used as a complementary to the current ratio.