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Liquidity Ratio – Definition, Uses, Types, Formula & Examples

Liquidity ratio is a ratio that evaluates a company’s ability to set off its short-term obligations. Read this blog to learn more about the liquidity ratio.

The ability of a business to convert assets into cash or to get cash—through a loan or cash in the bank—to meet its short-term liabilities or commitments is known as liquidity. Liquidity is a vital component of every firm. A business must have the liquidity to satisfy its short-term obligations. Liquidity ratios assess a company’s capacity to pay down its short-term liabilities. 

Liquidity ratios indicate how quickly a corporation can convert assets and use them to pay off debts. The higher the ratio, the easier it is to discharge debts and avoid payment defaults. This is a critical characteristic that creditors look at before making short-term business loans. An organisation that cannot pay its bills impacts its creditworthiness, which impacts the company’s credit rating.

Uses of Liquidity Ratio

Liquidity ratios are used to assess a company’s liquidity condition. High equity is often regarded as beneficial to the firm because it can meet present obligations if it has a significant equity reservoir.

However, it is also true that too much liquidity can harm the firm. As a result, organisations should maintain an optimal mix of stock and debt. Because liquidity ratios reveal the present mix of stock and debt, managers, owners, and investors may comprehend the actual state of the company’s health and make appropriate decisions.

Liquidity Ratio Types

Current ratio

The current ratio is the most straightforward liquidity ratio to compute and understand. Anyone may easily recognise the line items for current assets and current obligations on a balance sheet. The current ratio is calculated by dividing current assets by current liabilities.

Current Ratio = Current Assets/Current Liabilities

Current ratios can differ depending on the industry, firm size, and economic conditions. Consumer goods sectors, which have predictable, recurring revenue, frequently have lower current ratios, whereas cyclical industries, such as construction, have high current ratios. Current ratios might vary amongst organisations, even within the same industry.

Current assets Current liabilities Current ratio (current assets / current liabilities)
₹ 260 crores ₹ 130 crores ₹ 260 crore / ₹ 130 crores = 2:1

Quick ratio

Although commodities take longer to convert into cash and planned expenditure funds cannot be used to settle current liabilities, the quick ratio varies from the liquidity ratios in that they do not include inventory as well as prepaid expense accounts.

Nevertheless, depending on the organisation, some organisations may view inventories as a fast asset, albeit these instances are uncommon. A stricter liquidity assessment than even the current ratio is the fast ratio. Current assets serve as the numerator, and present liabilities serve as the denominator in both calculations.

However, the fast ratio only considers specific current assets. It considers more liquid assets, including cash, accounts receivable, and marketable securities. Current assets, such as inventories and prepaid expenses, are excluded since they are less liquid. As a result, the quick ratio is a more accurate indicator of a company’s capacity to meet its short-term obligations.

Quick Ratio = (Cash+ Debtors+ Marketable Securities)/ Currents Liabilities

Particulars Of current assets Amount in crore
Cash and equivalent ₹65,000
Marketable securities ₹15,000
Accounts receivables ₹35,000
Inventory ₹45,000
Total current assets ₹160,000
Total current liabilities ₹60,000
Current ratio As per formula 1 = (₹65,000 + ₹15,000 + ₹35,000)/ ₹60,000

= ₹115,000/₹60,000

= 1.91

As per formula 2 = (₹160,000 – ₹45,000)/₹ 60,000

= ₹115,000/₹60,000

= 1.91

Cash ratio

The liquidity test is made more difficult by the cash ratio. This ratio only considers a company’s most liquid assets, cash and marketable securities. They are the assets that a corporation has the most updated version to satisfy short-term obligations.

Cash ratio = (Cash+ Marketable Securities)/ Current Liabilities

In the worst-case situation, the cash ratio resembles a gauge of a company’s value — say, the corporation will exit the business. It informs analysts and creditors of the value of current assets that can be turned swiftly into cash and the percentage of a company’s current obligations that can cover those cash and approaching assets.

Particulars Of liquid assets Amount in crore
Cash and equivalent ₹ 1,65,000
Marketable securities ₹ 75,000
Accounts receivables ₹ 90,000
Inventory ₹ 1,00,000
Current liquid assets ₹ 4,30,000
Particulars Of Current liabilities Amount
Bills payables ₹ 90,000
Bank overdraft ₹ 80,000
Outstanding expenses ₹ 30,000
Creditors ₹ 1,00,000
Total current liabilities ₹ 3,00,000
Cash ratio (₹ 1,65,000 + ₹ 75,000)/₹ 3,00,000

= ₹ 2,40,000/₹ 3,00,000

=0.8

Basic Defence ratio

This ratio calculates the number of days a company can sustain its cash expenses without relying on outside finance.

(Cash+ Receivables+ Marketable Securities)/ (Operating expenses+ Interest+ Taxes)/ 365

Particulars of liquid assets Amount in crore
Cash and equivalent ₹1,05,000
Marketable securities ₹55,000
Accounts receivables ₹80,000
Current liquid assets ₹2,40,000
Particular of daily operational expenses Amount
Annual operating cost ₹5,00,000
Non-cash expenses ₹70,000
Daily operational expenses ₹4,30,000/365 = 1178
Basic defence ratio ₹2,40,000/1178

= 203

Importance

Evaluate the ability to cover short-term obligations

Investors and creditors can determine if and to what degree a firm can meet its short-term obligations using liquidity measures. A proportion of one is better than a proportion of less than one, even when imperfect. 

High cash ratios, such as those of 2 or 3, are desired by creditors and investors. A corporation is more likely to repay its short-term debts if the ratio is more excellent successfully. A ratio of less than one signifies unpleasant working capital and suggests that there may be a liquidity issue for the organisation.

Evaluating Creditworthiness

Liquidity ratios are used by creditors to decide the decision to provide or not a business credit. They want to be certain that the organisation to which they are lending can repay them. All signs of financial uncertainty may hinder an organisation from obtaining financing.

Determining the Worthiness of Investments

The Investors would use liquidity ratios to judge whether a firm is financially sound and worth investing in. Working capital restrictions will also affect the rest of the company. A firm must be able to pay its short-term bills with plenty of wriggle room.

Investors will eventually inquire why a firm’s liquid assets are so elevated. Investors can consider a company with a liquidity ratio of 8.5 overly risky even though it can unquestionably satisfy its short-term obligations. A high proportion means the company has a lot of liquid assets.

Analysts and investors, for example, could consider a cash ratio of 8.5 to be excessive. The corporation has surplus cash, yielding little more than the bank’s interest rate for storing its cash. It may be debated whether monies should be directed toward more profitable activities and investments.

With the help of liquidity ratios, businesses may strike a balance between inefficient capital allocation and their capacity to pay their payments safely. Capital should be used as effectively as feasible to raise the company’s value for shareholders.

Conclusion

If you have any queries regarding the Liquidity ratio other than the given information or any other tax or audit-related information, feel free to contact us at Vakilsearch! We are happy to help you. 

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