Liquidity means the capability of the company to meet its current liabilities as they become outstanding and current assets which presumably provide the source form which these responsibilities will be met. So they can be evaluated by looking at the current assets and current liabilities in the balance sheet. As these ratios are used to evaluate the short term solvency of the business thus they are also referred as short-term solvency ratios. Besides measuring liquidity, it also measures the scope of safety amiable in case of uncertainty of flow of fund. It has two parts –
(I) current ratio
(II) liquid ratio
(i)Current ratio or 2:1 ratio or working capital ratio
Meaning – current ratio represents the relationship between current assets and current liabilities. It can be computed by dividing current assets by current liabilities.
Formula for Calculation –
current ratio = current assets/current liabilities
Current ratio of 2:1 indicates a highly solvent or in the money position. However this thumb rule varies from industry to industry. If the current ratio is more than 2:1 it is valuable to the short- term creditors but is not essentially good for the business enterprise because a much higher ratio indicates heavy investment in current assets. The investments or savings in current assets usually have low profitability. If the current ratio is less than 2:1 it indicates lack of liquidity and scarcity of working capital. The ratio should be sensible otherwise the concern will not be able to pay its short-term debt in time.
(ii) Liquid ratio or quick ratio or acid test ratio
Liquid ratio is calculated by dividing liquid assets by current liabilities. Since it considers only those current assets which are liquid or can be converted easily into cash, it is called as liquid ratio. It is used to provide as an additional check on liquidity position of the company and is thus, also known as acid test ratio.
Liquid or quick or acid test ratio = liquid assets/ quick assets / current liabilities
Liquid ratio is used as an erasure of the firm capacity to meet its current responsibilities without any flow. The ratio of 1:1 specifies highly solvent position. If this ratio is less than 1:1: liquid assets are less than current liabilities than the financial position of the concern shall be deemed to be unsafe and additional cash will have to be provided for the payment of present liabilities.
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