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Liquidity Ratio or Working Capital Ratio

Liquidity Ratio or Working Capital Ratio

Liquidity ratio indicates that the firm has sufficient liquid resources to meet its short-term liabilities.

It measures the ability of the firm to meet its short-term obligations, i.e., capacity of the firm to pay its current liabilities as and when they fall due.

Also known as “short-term solvency ratio” or “working-capital ratio”. Thus these ratios reflect the short-term financial solvency of a firm.

 The various ratios that explains about the liquidity of the firm are

  1. Current Ratio
  2. Acid Test Ratio / quick ratio
  3. Absolute liquid ration / cash ratio

Liquidity Ratio or Working Capital Ratio

1. CURRENT RATIO

The current ratio measures the short-term solvency of the firm.  It establishes the relationship between current assets and current liabilities.

It is calculated by dividing current assets by current liabilities. An ideal ratio would be 2:1 which provides margin of safety to the creditors and financial stability.

Current Ratio =              Current Assets

                                                 Current Liabilities

 

Current assets cover

  • cash and bank balances
  •  marketable securities
  • inventory, and debtors, excluding provisions for bad debts and doubtful debtors
  • Bills receivables and prepaid expenses. 

Current liabilities include

  • sundry creditors
  •  bills payable
  •  short- term loans
  •  income-tax liability
  •  Accrued expenses and dividends payable. 

2. ACID TEST RATIO / QUICK RATIO/LIQUID RATIO

It has been an important indicator of the firm’s liquidity position and is used as a complementary ratio to the current ratio.

It establishes the relationship between quick assets and current liabilities.  It is calculated by dividing quick assets by the current liabilities.

Acid Test Ratio =           Liquid Assets

                                              Current liabilities

Liquid ratio is the true test of business solvency. The ideal ratio is 1:1 which indicates sound financial position.

3. ABSOLUTE LIQUID RATION / CASH RATIO

It shows the relationship between absolute liquid or super quick current assets and liabilities.

Absolute liquid assets include cash, bank balances, and marketable securities.

Absolute liquid ratio =       Absolute liquid assets

                                                Current liabilities

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