Liquidity Ratio — Microsoft Excel
In this article, we will discussing the liquidity ratio and we also have a look into its importance in accounting and finance, so we basically calculate the liquidity ratio is to understanding the company’s capability to pay short term obligation and in the paradigm of accounting and finance it is very helpful for liquidate all current assets of a company.
Let’s Dive In
Liquidity Ratio
They are calculated to understand the company’s capability to pay short term obligations. Liquidity refers to liquidating all current assets to meet all obligations
or debt of all current liabilities. Liquidity ratios are also known as working capital ratios because they define the current, immediate scenario of the company without
raising external capital. It is compared with peer competitors or with the company’s own performance in the previous years. The comparison cannot happen across industries, Let’s take an
example to understand, a coal manufacturing company cannot be compared with a coal trading company and we will understanding working capital in the upcoming sections.
Three types of liquidity ratios are in trend:
- Current Ratio
- Quick Ratio
- Cash Ratio
Current Ratio
Current ratio is the major liquidity ratio to analyze the current obligations versus current
assets.
Current assets, means resources that are consumed or converted into cash within a
year. These are listed below.
- Cash and cash equivalents
- Bank deposits
- Marketable securities
- Short term investments
- Accounts receivable
- Inventory
- Prepaid expenses
- Short term loans and advances
Current liabilities means, liabilities or obligations that are to be paid within a year.
- Accounts payable
- Short term loans
- Cash credit and overdraft
- Advance from customers
- Outstanding expenses
- Term loan instalments
Let’s study the scenarios of current ratios:
If current Liabilities is greater
than current assets than, current ratio is less than one.
- There is high liquidity risk.
- Company might need to raise additional funds via debts or by investment.
- Company is unable to meet its short term obligations.
If Current Liabilities is less than current asset than, current ratio is more than one
- Company can easily meet its short term obligations.
- Current assets are utilized very well.
- Company’s financial status is good.
The ideal current ratio is 1.33 and a current ratio between 1.33 and 3 is healthy according to investors and lenders. If Current ratio is more than 3, it means current assets are not utilized properly and funds are stuck in inventories or accounts receivables. Let’s take an example to understand this better.
The figure below, shows the balance sheet for a liquidity ratio example. We will use the same
example for all liquidity ratios.
Now, we are applying the preceding equation to the balance sheet in the above figure.
Situation A
Situation B
As we can see, Situation A is better than Situation B. In Situation A, the company can meet its current obligations easily because it has more current assets than current
liabilities, while in Situation B, the company might be liquidated as its current assets are less than its current liabilities.
Quick Ratio
The quick ratio measures a company’s ability to meet its short term obligations with quick assets and quick assets are very short term assets.
Where quick assets, resources that are consumed or converted into cash very quickly, These are listed below.
- Cash and cash equivalents
- Bank deposits
- Marketable securities
- Short term investments
- Accounts receivable
- Short term loans and advances
And current liabilities are the same as those in the case of current ratio.
Let’s study the scenarios of quick ratios.
If Current Liabilities greater than Quick Asset, quick ratio is less than one.
- There is high liquidity risk.
- The company might need to raise additional funds via debts or by investment.
- Company is unable to meet its short term obligations.
If Current Liabilities is less than Quick Asset, quick ratio is more than one.
- Company can easily meet its short term obligations.
- Current assets are utilized very well.
- Company’s financial status is good.
The ideal quick ratio is 1 and a quick ratio between 1 and 2.5 is healthy according to investors and lenders. If the QR is more than 2.5 it means quick assets are not
utilized properly and funds are stuck in accounts receivable.
Let’s take an example to understand this better.
We take the values of quick assets as mentioned in the Table:
Now, we will apply the preceding equation for calucuation of quick ratio, as shown in the above
Table and this table is a part of the balance sheet figure.
Situation A
Situation B
As we can see, Situation A is better than Situation B. In Situation A, the company can meet its current obligations easily because it has more quick assets than current
liabilities, while in Situation B, the company might be liquidated because its quick assets are less than its current liabilities.
Cash Ratio
The cash ratio tells us about the immediate liquidity position of the company, that is, at present within a few days.
Where quick assets, resources consumed or converted into cash very quickly and these are listed below:
- Cash and cash equivalents
- Bank deposits
- Marketable securities
- Short term investments
And the current liabilities are the same as in current ratio.
Let’s study the scenarios of cash ratios:
If the cash ratio is less than 0.5 or (<0.5)
- There is high liquidity risk.
- The company might need to raise additional funds via debts or by investment.
- Company is unable to meet its short term obligations.
If the cash ratio is more than 0.5 or (>0.5).
- Company can easily meet its short term obligations.
- Current assets are utilized very well.
- Company’s financial status is good.
There is no ideal cash ratio parameter, but companies, lenders, investors and bankers
consider the ideal cash ratio to be between 0.5 and 1. If the cash ratio is more than 1, it means cash is not utilized properly and funds are stuck in the form of cash.
Sometimes, liquidity ratios misguide in industries like infrastructure or real estate as
they cannot maintain ideal liquidity ratios.
Let’s take an example to understand this better.
we take the values of cash and cash equivalents as mentioned in the table:
Now, we will apply the preceding equation for calculation of Cash Ratio, as shown
in the above table and this table is part of previous balance sheet figure.
Situation A
Situation B
As we can see, Situation A is better than Situation B. In Situation A, the company can meet its current obligations easily because it has ideal cash than current liabilities
while in Situation B, the company might be liquidated because it has not as much as cash it should be.
Conclusion
Finally, we will understanding the core concept of liquidity ratio and it’s different types, we will learning how liquidity ratios is important in accounts and finance and through this we can easily get to know our business financial situation and we also understanding the current, quick and cash ratios in accounting and finance perspectives and along with that, we also covered how it working in any business or company.
