Accounting Ratios Notes2

Study Material & Notes for the Chapter 11

COMPANY - ACCOUNTING RATIOS

II.  LIQUIDITY RATIOS

A.  Meaning
  • 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.  
  • Very high Liquid ratio shows funds idleness

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