The liquidity ratios measure the ability of a firm to meet its short-term obligations and reflect the short-term financial strength/solvency of a firm.
The term liquidity is described as
convertibility of assets ultimately into cash in the course of normal business
operations and the maintenance of a regular cash flow. A sound liquid position
is of primary concern to management from the point of view of meeting current
liabilities as and when they mature as well as for assuring continuity of
operations. Liquidity position of a firm depends upon the
amount invested in current assets and the nature of current assets. The under
mentioned ratios are used to measure the liquidity position:-
ՖՖ current ratio
ՖՖ liquid (or) quick ratio
ՖՖ cash to current assets ratio
ՖՖ cash to working capital ratio
The most widely used measure of liquid position of an enterprise is the current ratio, i.e., the ratio of the firm’s current assets to current liabilities. It is calculated by dividing current assets by current liabilities:
Current Ratio = -------------------
The current assets of a firm represent those assets which can be in the ordinary course of business, converted into cash within a short period of time, normally not exceeding one year and include cash and bank balance, marketable securities, inventory of raw materials, semi-finished (work-in-progress) and finished goods, debtors net of provision for bad and doubtful debts, bills receivable and pre-paid expenses. The current liabilities defined as liabilities which are short-term maturing obligations to be met, as originally contemplated, within a year, consist of trade creditors, bills payable, bank credit, provision for taxation, dividends payable and outstanding expenses. N.l.hingorani and others observe:
“current ratio is a tool for measuring the short-term stability or ability of the company to carry on its day-to-day work and meet the short-term commitments earlier”. Generally 2:1 is considered ideal for a concern i.e., current assets should be twice of the current liabilities. If the current assets are two times of the current liabilities, there will be no adverse effect on business operations when the payment of current liabilities is made. If the ratio is less than 2, difficulty may be experienced in the payment of current liabilities and day-to-day operations of the business may suffer. If the ratio is higher than 2, it is very comfortable for the creditors but, for the concern, it indicates idle funds and lack of enthusiasm for work.
Liquid (Or) Quick Ratio: liquid (or) quick ratio is a measurement of a firm’s ability to convert its current assets quickly into cash in order to meet its current liabilities. It is a measure of judging the immediate ability of the firm to pay-off its current obligations. It is calculated by dividing the quick assets by current liabilities:
Liquid Ratio = ---------------------
The term quick assets refers to current assets which can be converted into cash immediately or at a short notice without diminution of value. Thus quick assets consists of cash, marketable securities and accounts receivable. Inventories are excluded from quick assets because they are slower to convert into cash and generally exhibit more uncertainty as to the conversion price.
This ratio provides a more stringent test of solvency. 1:1 ratio is considered ideal ratio for a firm because it is wise to keep the liquid assets atleast equal to the current liabilities at all times.
Cash To Current Assets Ratio:
Efficient management of the inflow and outflow of cash plays a crucial role in the overall performance of a business. Cash is the most liquid form of assets which safeguards the security interest of a business. Cash including bank balances plays a vital role in the total net working capital. The ratio of cash to working capital signifies the proportion of cash to the total net working capital and can be calculated by dividing the cash including bank balance by the working capital. Thus,
Cash To Working Capital Ratio = --------------------
Cash is not an end in itself, it is a means to achieve the end. Therefore, only a required amount of cash is necessary to meet day-to-day operations. A higher proportion of cash may lead to shrinkage of profits due to idleness of resources of a firm.