The term liquidity refers to the ability of the company to meet its current liabilities.

Liquidity ratios are financial ratios that help in analyzing the ability of a business entity to meet its short-term obligations/liabilities.

Liquidity ratios measure the firms’ ability to fulfil short term commitments out of its liquid assets

These are analysed by looking at the amounts of current assets and current liabilities in the balance sheet.

Higher ratio means better capacity to meet its current obligation.

B. Type

1. Current Ratio

2. Liquid Ratio

C. Current Ratio

a. Meaning

The Current ratio measures the ability of a company to pay its current liabilities using its current assets.

A higher Current ratio indicates that the company has sufficient current assets to meet its current liabilities.

b. Formula

It is calculated by dividing Current Assets by Current Liabilities.

Current Ratio = Current AssetsCurrent Liabilities

Current Assets = Current Investments + Inventories (excluding stores & spares and Loose tools) + Trade Receivables (Net of provisions) + Cash & Cash equivalents + Short Term Loans & Advances + Other Current Assets

Current Liabilities = Short Term Borrowings + Trade Payables + Other Current Liabilities + Short Term Provisions

Working Capital = Current Assets – Current Liabilities

c. Important Considerations

The ratio is expressed pure i.e. 2:1

The ideal range for the Current ratio is 2:1

A Current ratio of less than 1 indicates that the company may have difficulty meeting its current liabilities.

Higher Current ratio means better capacity to meet its current obligations.

Very high Current ratio shows funds idleness

D. Liquid Ratio

a. Meaning

The Liquid ratio is a more stringent measure of liquidity. It measures the ability of a company to meet its current liabilities using its quick assets, which include cash, marketable securities, and accounts receivable.

Its based on highly liquid assets that can be converted into cash quickly

The Liquid ratio is also known as Quick ratio or Acid-test ratio.

b. Formula

It is calculated by dividing Liquid Assets by Current Liabilities.

Liquid Ratio = Liquid Assets/Current Liabilities

Liquid Assets = Current Investments + Trade Receivables (Net of provisions) + Cash & Cash equivalents + Short Term Loans & Advances + Other Current Assets excluding Prepaid Expenses

Current Liabilities = Short Term Borrowings + Trade Payables + Other Current Liabilities + Short Term Provisions

Liquid Assets = Current Assets – Inventories – Prepaid Expenses

c. Important Considerations

The ratio is expressed pure i.e. 2:1

The ideal range for the Liquid ratio is 1.5 : 1

A Liquid ratio less than 1 indicates that the company may have difficulty meeting its current liabilities even if all of its current assets are liquidated.

Higher Liquid ratio means better capacity to meet its current obligations.