Liquidity Ratios

Liquidity Ratio is that show the relationship of a firm’s cash and other current assets to its current liabilities.

Liquidity Ratio is that show the relationship of a firm’s cash and other current assets to its current liabilities.

There are two commonly used liquidity ratios as follow: -

Current Ratio is computed by dividing current assets by current liabilities. It indicates the extent to which the claims of short-term creditors are covered by assets expected to be converted to cash in the near future. Can the company pay its near term bills? The current ratio measures this:

        Current ratio   =     Current Assets   

                                   Current Liabilities

In the case of our example company

        Current ratio   =     125   

                                     62

                             =   2.01

indicating that it has significantly more short-term assets than short-term liabilities - this would be considered prudent (a current ratio less than 1 is cause for worry).

Quick, or Acid Test Ratio is computed by deducting inventories from current assets and dividing the remainder by current liabilities. Can the company be easy to quickly convert to cash so a tighter measure of solvency (the ability to pay debts when they become due).

        Quick, or acid test ratio   =    Current Assets - Inventories  

                                                          Current Liabilities

So, for our example company:

        Quick, or acid test ratio   =     125 - 35   

                                                        62

                                            =   1.45  

If the quick ratio is less than 1 the company could not meet all its current liabilities should they be due immediately.