**Liquidity Ratio**

Liquidity ratio is a financial ratio that measure a company’s ability to repay both short and long-term obligations.

**Current Ratio = Current Assets ÷ Current Liabilities**

It evaluates the ability of a company to pay short-term obligations using current assets (cash, marketable securities, current receivables, inventory, and prepayments). The ratio of 1 is considered to be ideal that is current assets are twice a current liability, then no issue will be in repaying liability, and if the ratio is less than 2, repayment of liability will be difficult and work effects.

**Acid Test Ratio = Quick Assets ÷ Current Liabilities**

Also known as “quick ratio”, it measures the ability of a company to pay short-term obligations using the more liquid types of current assets or “quick assets” (cash, marketable securities, and current receivables).

Quick Ratio: ((Current Assets - Inventory) / Current Liabilities)

Quick Ratio: A more stringent measure of liquidity than the current ratio, as it excludes inventory from current assets.

Calculation: For example, if a company’s current assets are $500,000, its inventory is $200,000, and its current liabilities are $300,000, then its quick ratio is 1.

**Cash Ratio = ( Cash + Marketable Securities ) ÷ Current Liabilities**

Measures the ability of a company to pay its current liabilities using cash and marketable securities. Marketable securities are short-term debt instruments that are as good as cash.

**Net Working Capital = Current Assets – Current Liabilities**

Determines if a company can meet its current obligations with its current assets; and how much excess or deficiency there is.

**Absolute Liquidity = Cash + Marketable Securities + Net Receivable and Debtors**

Absolute Liquidity helps to calculate actual liquidity, and for that, inventory and receivables are excluded from current assets. For a better view of liquidity, some assets are excluded that may not represent current cash flow. Ideally, the ratio should be 1:2.

**Days Sales Outstanding (DSO) Formula: (Average Accounts Receivable / Credit Sales) x 365**

Days Sales Outstanding (DSO): Measures the average number of days it takes a company to collect payment from its customers.

Calculation: For example, if a company’s average accounts receivable are $50,000 and its credit sales are $1,000,000 per year, then its DSO is 18.25.

**Working Capital Turnover Ratio Formula: (Net Credit Sales / Average Working Capital)**

Working Capital Turnover Ratio: Measures how efficiently a company manages its working capital, which is the difference between current assets and current liabilities.

Calculation: For example, if a company’s net credit sales are $1,000,000 per year and its average working capital is $100,000, then its working capital turnover ratio is 10.

**Solvency Ratios**

**Examples, Ouestions and Answers of Liquidity Ratio**

**1. Calculate Liquid Ratio from the given details.**

Current Liabilities | 65,000 |

Current Assets | 85,000 |

Stock | 20,000 |

Advance Tax | 5,000 |

Prepaid Expense | 10,000 |

Solution:

Quick Ratio = Quick Assets / {Current Liabilities/Quick Liabilities}

Quick Assets = All Current Assets – Stock – Prepaid Expenses = 85000 – (20000+5000+10000) = 50,000

Quick Liabilities = All Current Liabilities – Bank Overdraft – Cash Credit = 65,000

Quick Ratio = 50000/65000 = 0.77:1

**2. Computation of current assets when current liabilities and current ratio are given.**

**If current ratio is 1.5 and total current liabilities are $500,000, what are total current assets?**

Solution

Current ratio = Current assets/Current liabilities

1.5/1 = Current assets/$500,000

Current assets = 1.5 × $500,000

Current assets = $750,000

**3. Compute current ratio, quick ratio and absolute liquid ratio from the following are the current assets and current liabilities of a trading company:**

Current assets:

Cash and Bank: $5,000

Marketable securities: $18,000

Accounts receivables, net: $8,000

Inventories: $10,000

Prepaid expenses: $500

Current liabilities:

Accounts payable: $15,000

Accrued payable: $5,000

Notes payable: $8,000

Required: Compute current ratio, quick ratio and absolute liquid ratio from the above data.

Solution

(1). Current ratio:

Current assets/Current liabilities

= $41,500 / $28,000

= 1.48

or

1.48 : 1

(2). Liquid ratio:

Liquid assets/Current liabilities

= $31,000* / $28,000

= 1.1

or

=1.1 : 1

(3). Absolute liquid ratio:

Absolute liquid assets/Current liabilities

= $23,000** / $28,000

= 0.82

or

0.82 : 1

*Liquid assets: $5,000 + $18,000 + $8,000 = $31,000

**Absolute liquid assets: $5,000 + $18,000 = $23,000

**4. Computation of current liabilities when current assets and current ratio are given.**

**The Hello company’s current ratio is 2.5 : 1 for the most recent period. If total current assets of the company are $7,500,000, what are total current liabilities?**

Solution

Current ratio = Current assets/Current liabilities

2.5/1 = $7,500,000/Current liabilities

2.5 × Current liabilities = $7,500,000

Current liabilities = $7,500,000/2.5

Current liabilities = $3,000,000

**5. Current ratio can be easily manipulated by equal increase and/or equal decrease in current assets and current liabilities. For example, if current assets of a company are $10,000 and current liabilities are $5,000, the current ratio would be 2:1 as computed below:**

$10,000 : $5,000

2:1

If both current assets and current liabilities are reduced by $1,000, the ratio would be increased to 2.25:1 as computed below:

$9,000 : $4,000

2.25:1

In order to overcome these limitations, current ratio may be used in conjunction with some other ratios like inventory turnover ratio, debtors turnover ratio, average collection period ratio, current cash debt coverage ratio, debt to equity ratio and quick ratio etc. These ratios can test the quality of some individual current assets and together with current ratio provide a better idea of company’s solvency.

**6. The Hello company has the following balance of Current Assets and Current Liabilities in its Statement of Financial Position for the year ended 31 December xxxx. What is the Current Ratio of the Hello company? **

Current Assets:

Cash and Cash Equivalents: $30,000

Account Receivable: $150,000

Inventories: $200,000

Others current Assets: $100,000

Current Liabilities:

Account Payable: $25,000

Current Tax Payable: $140,000

Accrual Expenses: $150,000

Overdraft: $90,000

What is the Current Ratio of the above company?

Answer:

So now is time for us to calculate the current ratio. And here is the information provided in the scenario:

Total Current Assets: $480,000

Total Current Liabilities: $405,000

Base on the information that we have above, here is the answer:

Current Ratio: 1.2 ($480,000/405,000)

Sources: PinterPandai, Wikipedia, Corporate Finance Institute