In our previous blog post we discussed ratio analysis. In this blog post we will explain classification of ratios and discuss Liquidity ratio.
Ratios are classified on the basis of the parties of their usage. Accounting ratios are used to indicate the financial position of a firm. Ratios are classified:
On the basis of Balance Sheet
On the basis of Profit & Loss Account
On the basis of Mixed Statement
The above classification further grouped into:
The scope to which there is quick convertibility of assets in to money, for the purpose of paying obligation of short-term nature can be termed as liquidity. Apropos to obtaining an indication of a firm’s ability to meet its current liabilities, the utility of the liquidity ratios is instrumental. As a flipside, however, it does not bring to the light, the effectiveness of the optimal management of cash resources. It is also termed as Short-Term Solvency Ratios. To measure the liquidity of a firm, the following Liquidity ratios are commonly used:
1) Current Ratio:
The relationship between current assets and current liabilities is established by Current Ratios. . It attempts to measure the ability of a firm to meet its current obligations. Current assets and current liabilities comprise of two pivotal components of this ratio. Assets that can be easily converted into cash, within the time frame of less than a year, can be termed as current assets. While, conversely, current liabilities encompass those liabilities which can be paid off with in a year.
Current Ratio = Current Assets / Current Liabilities
The ideal current ratio is 2: 1. It is a stark indication of the financial soundness of a business concern. When Current assets double the current liabilities, it is considered to be satisfactory. Higher value of current ratio indicates more liquid of the firm’s ability to pay its current obligation in time.
Advantages of Current Ratio:
It measures the liquidity of the firm
It represents the working capital position of a firm
It represents the liquidity of a company
It represents margin of safety
Its tells us the short term solvency of a firm.
Disadvantages of Current Ratio:
Its accuracy can be deterred as, pertaining to different businesses, depending on a variant of factors
Over-valuation of stock also contributes to its tipping accuracy
It measures the firm liquidity on the basis of quantity and not quality, which comes across as a crude method.
2) Quick Ratio or Acid Test Ratio:
The acid test ratio is a stringent and meticulous test of a firm’s ability to pay its short-term obligations ‘as and when they are due. Quick assets and current liabilities can be associated with the help of Quick Ratio.
The ideal Quick Ratio is 1: 1 and is considered to be appropriate. High Acid Test Ratio is an accurate indication that the firm has relatively better financial position and adequacy to meet its current obligation in time.
Quick Ratio = Liquid Asset (Current Assets – Stock & Prepaid Expenses) / Current Liabilities
Advantages of Quick Ratio:
It tells us the liquidity position of a firm
It is used to remove the errors of current ratio
It is used as supplementary to the current ratio.
3. Absolute Liquid Ratio:
The relationship between the absolute liquid assets and current liabilities is established by this ratio.
Absolute Liquid Assets take into account cash in hand, cash at bank, and marketable securities or temporary investments. The most favourable and optimum value for this ratio should be 1: 2. It indicates the adequacy of the 50% worth absolute liquid assets to pay the 100% worth current liabilities in time. If the ratio is relatively lower than one, it represents the company’s day-to-day cash management in a poor light. If the ratio is considerably more than one, the absolute liquid ratio represents enough funds in the form of cash in order to meet its short-term obligations in time.
Absolute Liquid Ratio = Absolute Liquid Ratio / Current Liabilities
So that were the 3 important Liquidity ratios that one must know in order to find out the short term solvency position of a company. In our next blog we shall learn about profitability ratio.