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
- Current Ratio
- Acid Test Ratio / quick ratio
- Absolute liquid ration / cash 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
Strategic Management Notes 