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‘Liquidity’ has a big role in business which is essential in a business to fulfill its short period commitment. In other words ‘Liquidity Ratio’ defines a company’s potential to repay short-time creditors out of its whole cash. It’s the outcome of parting the total cash by short-time borrowings, which denotes the no. of times short period liabilities are balanced by cash. Liquidity Ratio computes how fast assets can transform into cash so as to pay the short-term obligation of the company. Higher the ratio, effortless is the capacity to cover the debt and eliminate the error on payment. However, it is very important for creditors to know prior to offering short period loans to the business. Any organization that fails to clear the debt will result in building a large impact on the company and also affects the company’s credit ratings.
In this article, you will learn all the essentials you need to know about Liquidity Ratio. Read the complete article for Definition, Type, Formula and Examples.
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Types of Liquidity Ratio
The Liquidity Ratios has numerous ratios which are to investigate the financial position of a company. Given below are the available types of Liquidity Ratios;
1. Current Ratio
The Current Ratio can be defined as the easiest Liquidity Ratio that is used to calculate and interpret the financial stability of a company. With the help of this ratio, one can easily figure out the current assets and current liabilities line units on the company’s annual report. Commonly, 2:1 is adopted as the ideal ratio and differs depending on the type of industry.
Example
| Current Assets | Current Liabilities | Current Ratio (current assets / current liabilities) |
| Rs. 260 crore | Rs. 130 crore | Rs. 260 crore / Rs 130 crore = 2:1 |
2. Quick Ratio/ Acid Test Ratio
Quick Ratio test is one of most suitable measures to test liquidity in the company. Compared with Current Ratio, Quick Ratio is more conventional. The Quick asset is calculated by balancing the current assets to remove assets that are not in cash. Generally, the ratio 1:1 is considered as an ideal.
Example
| Current Assets Particulars | Amount (Crore) |
| Marketable Securities | Rs 15,000 |
| Cash and Equivalents | Rs 65,000 |
| Inventory | Rs 45,000 |
| Accounts Receivables | Rs 35,000 |
| Total Current Assets | Rs 160,000 |
| Total Current Liabilities | Rs 60,000 |
| Current Ratio | According to formula 1 = sum( 15,000 + 65,000 + 35,000) / 60,000
=1.91 According to formula 2 = sum(160,000 – 45,000)/ 60,000 = 115,000/60,000 = 1.91 |
3. Cash Ratio
Cash Ratio computes the company’s liquid assets such as cash, tradable securities. Company utilizes this asset to pay short-term commitment. However, money is the most liquid form of assets, this ratio tells us the speed and limit at which a company can repay its present dues by using readily available assets.
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4. Absolute Liquid Ratio
This ration is primarily used to measure the liquidity total accessible to the company. The Absolute Liquidity Ratio appraises only marketable securities and cash obtainable to the company. The ratio only measures short-term liquidity in the form of marketable securities, current investment and cash.
Example
| Liquid Assets Particulars | Amount in Crore | Current Liabilities Particulars | Amount in Crore |
| Cash and Equivalent | Rs 1,65,000 | Bills Payables | Rs 90,000 |
| Marketable Securities | Rs 75,000 | Bank Overdraft | Rs 80,000 |
| Accounts Receivables | Rs 90,000 | Outstanding Expenses | Rs 30,000 |
| Inventory | Rs 1,00,000 | Creditors | Rs 1,00,000 |
| Current Liquid Asset | Rs 4,30,000 | Total Current Liabilities | Rs 3,00,000 |
| Absolute Liquidity Ratio | (Rs 1,65,000 +Rs 75,000)/ Rs 3,00,000
= Rs 2,40,000/ Rs 3,00,000 = 0.8 |
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5. Basic Defense Ratio
The Basic Defense Ratio computes the number of days a company counterbalances money expenses without the help of supplementary financing from other fount.
Example
| Liquid Assets Particulars | Amount in Crore |
| Cash and Equivalent | Rs 1,05,000 |
| Accounts Receivable | Rs 80,000 |
| Marketable Securities | Rs 55,000 |
| Current Liquid Assets | 2,40,000 |
| Daily Operational Expenses Particulars | Amount |
| Annual Operating Cost | Rs 5,00,000 |
| Non-cash Expenses | Rs 70,000 |
| Daily Operational Expenses | Rs 4,30,000/365
= 1178 |
| Basic Defense Ratio | Rs 2,40,000/ 1178
= 203 |
6. Basic Liquidity Ratio
Apart from all the above stated liquid ratios, Basic Liquid Ratio is not based on the company’s financial status. But it’s an individual financial ratio which indicates a schedule for how far a family can finance its requirement with its liquid assets. However, monetary backup is advisable for a minimum of three months.
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Liquid Ratio Formula
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Check out the below given table for different liquid ratio formula;
| Liquidity | Formula | Details |
| Current Ratio | Current Assets / Current Liability
|
Where;
▪ Current Assets:- Debtor, Cash, Stock, Cash and Banks, Advance and Loans, Receivables and other current assets. ▪ Current Liability:- Short-term loan, Bank Overdraft, Outstanding Expenses, Creditor and other current liabilities.
|
| Quick Ratio/ Acid Test Ratio | Quick Ratio = Quick Assets / Current Liability
|
Where;
▪ Quick Assets = Current Assets – Inventory – Prepaid Expense
|
| Cash Ratio | Cash Ratio = Cash + Equivalent / Current Liabilities
|
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| Absolute Liquid Ratio | Absolute Liquid Ratio = (Cash + Marketable Securities)/ Current Liability
|
– |
| Basic Defense Ratio | Basic Defense Ratio = (Current assets) / (Daily Operating expenses) | Where;
▪ Current assets = Marketable Securities + Cash and Equivalent + Receivables ▪ Daily Operational Expense = (Annual Operational Costs – Non-cash Expenses) / 365
|
| Basic Liquidity Ratio | Basic Liquidity Ratio = Monetary assets / Monthly Expenses |
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Any company with better liquidity ratios has more ability to clear debt on the right period, meanwhile companies with poor liquidity struggles to do so. A relative liquidity ratio weighs up liquidity of one firm with the other of the same industry with almost identical working cycles and business. Hope the article ‘Liquidity Ratio: Definition, Type, Formula, Examples’ was informative for the readers.
