Liquidity Ratio


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The impotence of adequate liquidity in the sense of the ability of the firm to meet current or short term obligations when  they become due for payment can hardly be over stressed.  The short term creditors of the firm are interested in the short term solvency or liquidity of a firm.

 

The liquidity ratios measures the ability of the firm to meet its short term obligation and reflect the short term financial strength or solvency of a firm.  These ratios are also termed as working capital or short term solvency ratio.  Enterprises must have adequate working capital to run its day to day operation.

 

The ratios are of much help to short term creditors like trade creditors bankers and other short term lenders as it indicates the capacity of the concern to pay off its short term obligations they also help employees share holders and management.

The important liquidity ratios are:

 

  1. Current Ratio
  2. Quick Ratio
  3. Inventory to working capital ratio.

 

i.        Current Ratio

Current Ratio is the ratios of total current assets to total current liability.  It is calculated by dividing current asset by current liabilities.

Current Ratio:        Current Assets/Current Liabilities

The current ratio of a firm measures its short term solvency i.e., its ability to meet short term obligation current assets represents those assets which can be readily converted into cash within a short period of time current liability are short term maturing obligation to be meet within a year.  The ideal current ratio is 2:1.

 

ii.       Quick Ratio

 

This ratio is ascertained by comparing the quick assets and quick liabilities thus it is a measure of quick or acid liability.  It is compared with the standard ratio is 1:1.

 

Quick asset refers to current assets which an be converted into cash immediately quick liabilities refers to liabilities which are payable within a short period.  The bank over draft and cash credit facilities will be excluded from current liabilities.

 

iii.      Inventory to working capital ratio

 

The ratio indicates the proposition of working capital tied up inventories or stocks and there by throws.  Focus light on the liquidity of a concerns.  It also indicates whether there is overstocking or under stocking.  Ti is expressed as a percentages as per the standard ratio the inventories should not absorb more than 75% of working capital.

 

 

Inventory to working capital =       Inventory/Working Capital * 100

 

 


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