Those ratios are considered as liquidity ratios that measure the liquidity position and short-term solvency-indicating the company’s ability to meet its short-run obligations. It means ratios that measure the debtor’s ability to pay its short-term obligations from current or liquid assets without raising external capital is known as liquidity ratios.
This ratio stresses on current assets and current liability of a firm. It determines the firm’s ability to cover short-term obligations and cash flows. The ratios that are used to test the liquidity of a firm are:
Current Ratio (CR)
The ratios which show the relationship between the firm’s current assets and current liability is called current ratios. The assets which can be converted into cash within a year may be defined as current assets like cash, bank deposit, marketable securities, sundry debtors, bills receivable, account receivable, prepaid expenses, short-term loans, and advances to others, and inventory. And current liabilities are debts that will come due within a year like a bank overdraft and cash credit, sundry creditors, account payable, short-term loans, advance from customers, term loan installment, and bills payable and outstanding expenses.
Thus, Current Ratio (CR) = Current Assets (CA)/Current Liabilities (CL)
If the current ratio is too low, the firm may have difficulty in meeting short-run commitments as they mature and if it is too high, the firm may have an excessive investment in current assets and underutilizing short term credit.
Interpretation: The less or more than the standard current ratio is not desirable or preferable. If it is less than the standard ratio, it will show the bad solvency position and vice versa. Usually, a current ratio of 2:1 is considered acceptable.
Example: If the value of current assets is Rs. 350 thousand and current liabilities are Rs. 500 thousand. Then the current ratio can be calculated as;
CR= CA/CL= Rs. 350/Rs. 500= 0.7
Again if a current asset is Rs. 600 thousand and current liabilities are Rs. 200 thousand. Then the current ratio can be calculated as;
CR= CA/CL = Rs. 600/ Rs. 200 = 3
Here in the first case, the coefficient of the current ratio is 0.7. It indicates that;
- Current liabilities are greater than the current assets of the company
- Short term trouble for the company-liquidity risk would high
- May have to raise additional long term financing
- The firm is not able to fulfill current obligations due to a shortage of current assets.
In the second case, the value of the current ratio is 3. It indicates that;
- Current assets are greater than current liabilities
- The company can easily meet its short term liabilities.
- A higher current ratio is also not good for the profitability of the company. The current ratio higher than the ideal ratio or standard ratio denotes inefficiency in the utilization of current assets. It means funds are either not utilized or locked up in inventories or in receivable.
Quick Ratio (QR)
The ratios which show the relationship between quick assets and current liabilities is known as quick ratios. Quick assets include all the current assets except inventories.
Thus, Quick Ratio (QR) = Quick assets /Current Liabilities
Thus quick assets are those assets that are converted into cash in the short term (2-3 months). If we deduct inventory and prepaid expenses from current assets then the remaining value is quick assets. So QA= Current Assets-Inventory- Prepaid expenses. In general Quick Assets=Current Assets-inventories.
Interpretation: The more or less than the standard ratio is not favorable for a company. Generally, a quick ratio of 1:1 is considered as the standard of comparison.
If Quick Ratio is less than one then its implications are;
- Quick assets are less than current liabilities
- There may be trouble for the company in the short run
- There is high liquidity risk
Again, if Quick Ratio is greater than one then its implications are;
- Quick assets are greater than current liabilities and the company has sufficient cash and cash equivalent to meet the current liabilities of the company.
- However, the quick ratio of more than 2 is not a desirable one. It indicates the inefficient utilization of funds of the company.
Cash Ratio (CR)
The ratio between cash and marketable securities (most liquid assets) to current liabilities is known as cash ratios. It can be calculated as:
Cash Ratio= Cash + Marketable Securities/Current Liabilities
The cash ratio is calculated to check whether or not the company can pay the current liabilities immediately. It means that the immediate liquidity position of the company is reflected by the cash ratio. For the analyst, the cash ratio may not matter that much (there is any standard cash ratio), but for a bank it is important. The bank may require a minimum of 0.5 cash ration of the company to lend the money easily. A higher cash ratio is also not desirable. Under the cash and cash equivalent, we can take cash and cash balance, bank balance, short term investment.
Thus in totality, either of the liquidity ratios is not able to analyze the entire financial situation of the company but they are the significant part of knowing the financial state of affairs of the company.