Liquid ratio or quick ratio used in finance



quick ratio or liquid ratio is used in finance. It basically defines the ability of a company to completely dissolve its current liabilities or short-term debts obligation by utilizing its assets and cash. The higher liquidity of a company increases its chances to cover short-term debts in case of emergency or a particular situation. A company with less than 1 quick ratio cannot payback its current liabilities. Company has to keep this ratio at least more than 1 in order to deal with the situation or insolvency or bankruptcy. Multinational companies or not so worried about these ratios as they won’t go in bankruptcy as compared to small public limited companies. This ratio is to be considered by other types of businesses as well like sole traders, partnerships, and private limited companies. Testing a company’s liquidity is obligatory in analyzing it. Short term refers to less than twelve months. The investors consider the liquid test ratio to be a great indicator of a company's performance; investors include banks and ordinary people who buy company's shares.

Imagine you invest all your money in a company and after a few months the company collapses. What will happen to your money? The only money you will be receiving is what will be left of the company after its liquidizing. In this scenario you would want to invest in a company which has adequate number of assets and money from which they can pay off their debts and give back your money.

The few formulas for liquidity ratios include:-
-Current Ratio = Current assets/current liabilities

-Liquidity= (current asset-inventories)/current liabilities

-Quick Ratio = (Accounts Receivable + Cash Equivalents + Cash)/(Accruals + Accounts Payable + Notes Payable)

-Cash Ratio = Cash and cash equivalents/ Current liabilities

-Receivable turnover ratio = Sales Revenue / average Receivables

-Avg No: of days = 365 / Receivable Turn over

-Inventory Turnover = Cost of goods sold/average inventory

When it comes to quick ratio, it does not always show the whole picture of the company. It shows the current status of the company to pay off its debts which means it will include the bills that are paid already but the ones to be paid are not included and the quick ratio will show that the company is having a good liquid ratio but in fact the future of the company is not secure.

For the better view of a company cash ratio can be used as well. In this ratio the inventory and other low level liquid assets are eliminated thus giving a good indication of the company’s ability to meet its current liabilities.

Receivable turnover ratio explains the company’s credit policy mainly. A high Receivable turnover ratio directs towards the fact that the company can collect its dues in time from its customers in time. A high ratio compared to rivalry may point that the company's credit policy is somehow at risk where the company does not supply sufficient credit capacity and might be behind on sales opportunity.

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Formula for Calculating Liquidity Ratio






The formula for calculating liquidity ratio is very simple and easy. It can be done by using figures in a balance sheet of a firm or company. There are two components in a liquidity ratio that is liquid assets and liquid liabilities. Liquid assets contains cash, bank, sundry debtors, bills receivable and marketable securities or temporary investments. In other words we can say that a liquid asset is current assets excluding inventories and prepaid expenses. Inventories cannot be consider as liquid assets because they cannot be converted into cash without a value loss.in the same way prepaid expenses cannot also be included in liquid assets because they cannot be converted into cash without a loss in value.

Similarly, Liquid liabilities means current liabilities i.e., sundry creditors, bills payable, unpaid expenses, short term advances, income tax payable, dividends payable, and bank overdraft (only if payable on demand). Sometime bank overdraft is not included in current liabilities; on the dispute that bank overdraft is generally permanent way of financing and is not topic to be called on demand. In the above mentioned circumstances overdraft will be expelled from current liabilities.

The formula for the liquidity ratio is as under

Liquid Ratio = Liquid Assets / Current Liabilities

It can also be written as

Liquid ratio= liquid assets: current liabilities

Example to calculate the Liquidity Ratio:

From the following information of a company, calculate liquid ratio. Cash $180; Debtors $1,420; inventory $1,800; Bills payable $270; Creditors $500 Accrued expenses $150; Tax payable $750.

Liquid Assets = 180 + 1,420 = 1.600

Current Liabilities = 270 + 500 + 150 + 750 = 1,670

Liquid Ratio = 1,600 / 1,670

Liquidity Ratio
= 0.958: 1


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Accounting for Management - Accounting theme from Business Law.