The term liquidity refers to the ability of the company to meet its current liabilities. Liquidity ratios assess capacity of the firm to repay its short term liabilities. Thus, liquidity ratios measure the firms’ ability to fulfill short term commitments out of its liquid assets.
The important liquidity ratios are:
Current ratio is a ratio between current assets and current liabilities of a firm for a particular period. This ratio establishes a relationship between current assets and current liabilities. The objective of computing this ratio is to measure the ability of the firm to meet its short term liability. It compares the current assets and current liabilities of the firm.
Current assets are those assets which can be converted into cash within a short period - not exceeding one year. It includes cash in hand, cash at Bank, trade receivables, short term investment, stock, prepaid expenses. Trade receivables include Bills Receivables and Sundry Debtors.
Current liabilities are those liabilities which are expected to be paid within a year. It includes trade payables, bank overdraft, provision for tax, outstanding expenses. Trade payables include Sundry Creditors and Bills Payables.
It indicates the amount of current assets available for repayment of current liabilities. Higher the ratio, the greater is the short term solvency of a firm and vice-versa. However, a very high ratio or very low ratio is a matter of concern. If the ratio is very high it means the current assets are lying idle. Very low ratio means the short term solvency of the firm is not good. Thus, the ideal current ratio of a company is 2:1 - to repay current liabilities, there should be twice current assets.
Quick ratio is also known as Acid test or Liquid ratio. It is another ratio to test the short-term solvency of the concern. This ratio establishes a relationship between quick assets and current liabilities. This ratio measures the ability of the firm to pay its current liabilities. The main purpose of this ratio is to measure the ability of the firm to pay its current liabilities. For the purpose of calculating this ratio, stock and prepaid expenses are not taken into account as these may not be converted into cash in a very short period.
Liquid assets = current assets – (stock + prepaid expenses)
Quick ratio is a measure of the instant debt paying capacity of the business enterprise. It is a measure of the extent to which liquid resources are immediately available to meet current obligations. A quick ratio of 1:1 is considered good for a company.