“The power of ratio lies in the fact that the numbers in the financial statement by themselves don’t reveal the whole story”-Karen Berman
A ratio is the mathematical relationship between two or more items in terms of proportion. Financial Ratios are created after we extract numerical data from the three key financial statements that are income statement, cash flow statement and balance sheet , apart from these three key financial statements we can extract the data from annual reports, interim financial statements, notes to account , business periodicals , credit and investment advisory services etc.
These financial ratios then depict different information that are used two different types of users, those are as follows-
- Internal users– Internal users are the body of individuals who work/deal within the organization and use these ratios to make decisions on a daily basis. For example the management, owner of the business and the employees.
- External users– External users are the body of individuals who work/deal outside the organization and use these ratios to take up decisions on the financial performance of the company. For example the investors, creditors, investment bankers etc.
With this we have progressed to the focus of this article’s discussion i.e Liquidity ratios.
What is LIQUIDITY RATIOS –
- The term “liquidity” refers to the ability of a firm to pay off its short term obligations. It clearly indicates how a company can convert the short term assets and use it to pay off its short term liabilities.
- Short term creditors and lenders of the business take great interest in knowing the liquidity of the business because of their financial stake.
- A company’s strong liquidity and sound financial condition are indicated if it has a lot of cash or other liquid assets on hand and can readily pay any debts that may become due in the near future. But, it could also be a sign that a business isn’t making enough investments.
- Poor liquidity indicates that the firm will struggle to grow because it lacks short-term funding and may not make enough money to cover its present obligations.
With having an understanding of liquidity ratios let’s look at the importance of liquidity ratios
- The liquidity ratio, used as a financial calculation statistic, shows how well-stabilized a company’s finances are and how well-equipped it is to pay its immediate financial obligations.
- Investors and creditors need to know this metric information since they typically view businesses with a liquidity ratio of one or higher as creditworthy or investor-attractive.
- A metric used to assess a company’s creditworthiness is the liquidity ratio. As a result, a favorable ratio can assist a business get credit because it shows that it can repay the loan quickly.
- A larger ratio suggests that the business is stable, whereas a low ratio raises the possibility of financial losses.
- It also demonstrates how effectively the business can turn its inventories into cash. It determines how a business behaves in the marketplace.
a) Current Ratio
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- A current ratio is measured by the division of total current assets by total current liabilities.
- Formula = Total Current Assets/ Total Current Liabilities
- It indicates that a company has sufficient current assets to satisfy its current liabilities that have occurred for a duration of 1 year.
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A few pointers to keep in mind while calculating the current ratio-
| If Current Assets> Current Liabilities | Ratio will be greater than 1 which is a good position to be in |
| If Current Assets= Current Liabilities | Ratio will be equal to 1 which means the current assets are only enough to pay the current liabilities |
| If Current Assets <Current Liabilities | Ratio will be lesser then 1 which indicates that this is not a good position to be in as company does not have sufficient current assets to pay off its current liabilities |
(Also Read – Understanding the financial statement before investing in a company)
b) Quick Ratio
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- The quick ratio is also known as “acid test ratio”/ “liquid ratio”
- This ratio indicates the ability of a firm to pay off its short term liabilities with current assets that can be quickly converted into cash.
- The quick ratio is a more conservative approach of short term liquidity than the current ratio.
- The term “quick assets” refers to assets that can be quickly converted into cash.
- We don’t use inventory when computing quick assets, nor do we include other current assets like prepaid expenses, advance tax, etc.
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Formula=Total Quick Assets/Total Current Liabilities
c) Cash Ratio
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- The ability of a corporation to pay down obligations entirely using liquid assets (cash and cash equivalents such as marketable securities) is assessed using the cash ratio.
- The cash ratio is also known as the “absolute liquid ratio”.
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Formula=Cash+Marketable securities/ Total current liabilities
d) Basic Defence Interval Ratio
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- This ratio helps to understand that if the company”s business ceases for a while then this ratio would help to determine the number of days which the company can cover its cash expenses without aid of additional financing.
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Formula=Cash and bank balance+net receivables+marketable securities/ Daily operating expenses
e) Net Working Capital Ratio
- If a business has enough cash or money to keep running, it can be told by its net working capital ratio.
- Current Assets – Current Liabilities(exclude short term borrowing) is the Net Working Capital Ratio.
| Positive Working Capital | It indicates that the business has sufficient liquid assets to pay of immediate debts |
| Negative Working Capital | It indicates that the business does not have sufficient liquid assets to pay of immediate debts |
As we have come to the end of this article I want you to go back to your class 12th NCERT and solve these two questions on liquidity ratios
QUESTION 1
Calculate the current ratio from the following information:
Total assets = Rs. 3,00,000 Non-current liabilities = Rs. 80,000 Shareholders’ Funds = Rs. 2,00,000 Non-Current Assets: Fixed assets = Rs. 1,60,000 Non-current Investments = Rs. 1,00,000
ANSWER
Total assets = Non-current assets + Current assets
Rs. 3,00,000 = Rs. 2,60,000 + Current assets
Current assets = Rs. 3,00,000 – Rs. 2,60,000 = Rs. 40,000
Total assets = Equity and Liabilities = Shareholders’ Funds + Non-current liabilities + Current liabilities
Rs. 3,00,000 = Rs. 2,00,000 + Rs. 80,000 + Current Liabilities
Current liabilities = Rs. 3,00,000 – Rs. 2,80,000 = Rs. 20,000
Current Ratio = Current Assets/ Current Liabilities
Rs. 40,000/Rs 20000
= 2:1
QUESTION 2
Calculate ‘Liquid Ratio’ from the following information:
Current liabilities = Rs. 50,000 Current assets = Rs. 80,000 Inventories = Rs. 20,000 Advance tax = Rs. 5,000 Prepaid expenses = Rs. 5,000
ANSWER
Liquid Ratio = Liquid Assets/ Current Liabilities
Liquid Assets = Current assets – (Inventories + Prepaid expenses + Advance tax)
= Rs. 80,000 – (Rs. 20,000 + Rs. 5,000 + Rs. 5,000)
= Rs. 50,000
Liquid Ratio = Rs. 50,000/Rs 50000
=1:1
