Q.On the basis of given statements: Assertion (A) & Reason (R), choose the correct option: Assertion (A): "The biggest drawback of Liquidity ratios is that these are open to Window Dressing." Reason (R): "Current Ratio or Quick Ratio of more than 1 can be improved by equal decrease in current/quick assets and current liabilities. Therefore, it can easily be manipulated."
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🔒 Start your 14-day free trial to unlock the full solution →Concept understanding — Liquidity Ratio Analysis
Liquidity Ratio Analysis – A First Look
Think of your own pocket money. You get ₹500 at the start of the month. You know you'll need to pay ₹200 for a bus pass, ₹150 for stationery, and ₹100 for a friend's birthday gift. That's ₹450 of definite expenses. You have ₹500 cash in hand. You can easily cover those payments. That's liquidity – your ability to meet short-term obligations as they fall due.
Now imagine you have a ₹10,000 fixed deposit that matures in two years, but you need ₹500 today. You can't break the FD easily without a penalty. That asset is not liquid enough for today's need. Liquidity is about timing – having cash or near-cash when the bill arrives.
The Precise Meaning in Accountancy
In a business, liquidity means the firm's ability to pay its current liabilities (debts due within one year) using its current assets (assets that can be converted into cash within one year). The two most important ratios from NCERT Class 12 (Part B, Chapter 5 – Accounting Ratios) are:
- Current Ratio = Current Assets / Current Liabilities
- Quick Ratio (Acid Test Ratio) = Quick Assets / Current Liabilities
Where:
- Current Assets include: Cash, Bank, Debtors, Bills Receivable, Inventory, Prepaid Expenses, Short-term Investments.
- Current Liabilities include: Creditors, Bills Payable, Outstanding Expenses, Short-term Loans, Bank Overdraft.
- Quick Assets = Current Assets – Inventory – Prepaid Expenses (because inventory takes time to sell, and prepaid expenses cannot be converted to cash).
The ideal current ratio is 2:1 (₹2 of current assets for every ₹1 of current liability). The ideal quick ratio is 1:1. These are benchmarks, not rigid rules – a trading firm with fast-moving inventory can survive with a lower current ratio.
Why It Matters
A business that cannot pay its short-term debts is technically insolvent – even if it owns huge factories. Creditors, banks, and suppliers check these ratios before giving credit. A very high ratio (say 5:1) may mean idle cash or poor asset utilisation. A very low ratio (say 0.8:1) signals danger – the firm may default.
A high current ratio is not always good. If it comes from slow-moving inventory or old debtors, the firm may still struggle to pay cash. That's why the quick ratio is a stricter test.
Accounting Treatment – No Direct Journal Entry
Liquidity ratios are not recorded in the books of accounts. They are calculated from the Balance Sheet for analysis. There is no debit or credit entry for a ratio. The treatment is purely analytical:
- You take the Balance Sheet (prepared under Schedule III of Companies Act, 2013).
- Identify current assets and current liabilities from the prescribed format.
- Compute the ratios.
However, the components of these ratios do have accounting entries. For example, when you buy goods on credit:
- Debit Purchases A/c
- Credit Creditors A/c
This increases inventory (current asset) and creditors (current liability), affecting the current ratio. But the ratio itself is never journalised.
Format from NCERT – Balance Sheet Extract (Schedule III)
Below is the relevant part of the Balance Sheet format used to compute liquidity ratios. Only the current portions are shown.
| Particulars | Note No. | Amount (₹) |
|---|---|---|
| ASSETS | ||
| 1. Non-current Assets | ||
| (a) Property, Plant & Equipment | 1 | xxx |
| (b) Intangible Assets | 2 | xxx |
| 2. Current Assets | ||
| (a) Inventories | 3 | xxx |
| (b) Trade Receivables | 4 | xxx |
| (c) Cash & Cash Equivalents | 5 | xxx |
| (d) Short-term Loans & Advances | 6 | xxx |
| (e) Other Current Assets | 7 | xxx |
| Total Assets | xxxx | |
| EQUITY & LIABILITIES | ||
| 1. Shareholders' Funds | ||
| (a) Share Capital | 8 | xxx |
Both statements are true and the reason correctly explains the assertion: liquidity ratios can be window-dressed because an equal change in current assets and current liabilities alters the ratio. …
Both true and the reason explains the assertion.
Assertion: The biggest drawback of liquidity ratios is that they are open to window dressing - true.
Reason: A current/quick ratio above 1 can be improved by an equal decrease in current (quick) assets and current liabilities, so it is easily manipulated - true, and this is exactly why liquidity ratios are open to window dressing. For example, payi …
Showing the 12 most recent of 39 on this concept.
- CBSE 2026Set 67/3/11 markMCQQ.(a) Which of the following is a financial statement of a company ? (A) Common Size Statement of Profit and Loss (B) Statement of Profit and Loss (C) Comparative Balance Sheet (D) Comparative Statement of Profit and Loss(OR)(b) Which of the following is not a Solvency Ratio ? (A) Debt-Equity Ratio (B) Return on Investment (C) Interest Coverage Ratio (D) Proprietary Ratio
›Reveal solutionSolution
Part (a): (B) Statement of Profit and Loss is a financial statement; the others are analytical tools. Part (b): (B) Return on Investment is a profitability ratio, not a solvency ratio.
Part (a)
Under the Companies Act, 2013 the financial statements are the primary, statutory statements: the Balance Sheet, the Statement of Profit and Loss, and the Cash Flow Statement. Common Size and Comparative statements are analytical statements prepared from the financial statements for interpretation.
Option Nature (A) Common Size Statement of P&L Analytical tool (B) Statement of Profit and Loss Financial statement ✓ (C) Comparative Balance Sheet Analytical tool - CBSE 2026Set 67/3/11 markMCQQ.The Current Ratio of Megh Raj Ltd. is 1·5 : 1. Which of the following transactions will reduce the ratio ? (A) Sale of furniture of ₹ 18,000 at a loss of ₹ 2,000 (B) Goods purchased on credit ₹ 75,000 (C) Sale of goods costing ₹ 60,000 for ₹ 80,000 (D) Payment of trade payables ₹ 40,000
›Reveal solutionSolution
The transaction that will reduce the Current Ratio (from 1.5:1) is (B) Goods purchased on credit ₹ 75,000, because it increases current assets and current liabilities by the same amount, which lowers a ratio greater than 1:1.
Concept First: Why the Current Ratio Changes
The Current Ratio is Current Assets ÷ Current Liabilities. Megh Raj Ltd. has a ratio of 1.5:1 — meaning for every ₹1 of current liability, the firm holds ₹1.50 of current assets. This is a ratio greater than 1:1.
Here is the key rule you must remember:
ImportantWhen a ratio is greater than 1:1, adding an equal amount to both numerator (current assets) and denominator (current liabilities) reduces the ratio. When a ratio is less than 1:1, the same transaction increases the ratio.
Why? Think of it as a fraction. If you have 3/2 = 1.5, and you add 1 to both top and bottom, you get 4/3 ≈ 1.33 — which is smaller. The same logic applies to any transaction that increases both current assets and current liabilities by the same rupee amount.
Now let us examine each option.
Analysing Each Transaction
Option (A): Sale of furniture of ₹ 18,000 at a loss of ₹ 2,000
Furniture is a non-current asset (fixed asset). Selling it converts it into cash (a current asset). The book value of the furniture is ₹ 20,000 (since loss of ₹ 2,000 on sale of ₹ 18,000 means cost was ₹ 20,000).
- Effect on Current Assets: Cash increases by ₹ 18,000.
- Effect on Current Liabilities: No change.
- Effect on Current Ratio: Numerator increases, denominator unchanged → Ratio increases.
So (A) does not reduce the ratio.
Option (B): Goods purchased on credit ₹ 75,000
- Effect on Current Assets: Inventory (stock) increases by ₹ 75,000.
- Effect on Current Liabilities: Trade payables (creditors) increase by ₹ 75,000.
- Effect on Current Ratio: Both numerator and denominator increase by the same amount (₹ 75,000). Since the original ratio is 1.5:1 (>1:1), this reduces the ratio.
Let us verify with numbers. Suppose original current assets = ₹ 1,50,000 and current liabilities = ₹ 1,00,000 (ratio = 1.5:1). After the transaction:
Current assets = ₹ 1,50,000 + ₹ 75,000 = ₹ 2,25,000
Current liabilities = ₹ 1,00,000 + ₹ 75,000 = ₹ 1,75,000
New ratio = 2,25,000 ÷ 1,75,000 = 1.2857:1 — which is lower than 1.5:1.
So (B) reduces the ratio.
Watch outA common mistake is to think that any increase in current liabilities reduces the ratio. That is only true if current assets do not also increase. Here, both increase equally, so the effect depends on whether the original ratio is above or below 1:1.
Option (C): Sale of goods costing ₹ 60,000 for ₹ 80,000
This is a credit sale (or cash sale — either way, the effect is the same on current assets and liabilities).
- Effect on Current Assets:
- Inventory decreases by ₹ 60,000 (cost of goods sold).
- Debtors (or cash) increase by ₹ 80,000 (sale price).
- Net increase in current assets = ₹ 80,000 – ₹ 60,000 = ₹ 20,000.
- Effect on Current Liabilities: No change (assuming no credit purchase involved). …
- CBSE 2026Set 67/4/11 markMCQQ.(a) Which of the following statements are correct ? I. A low current ratio endangers the business and puts it at risk of facing a situation, where it will not be able to pay its short-term debts on time. II. Trade payables turnover ratio expresses the relationship between net credit sales and average trade payables. III. Operating profit ratio plus Gross profit ratio = 100. IV. Inventory turnover ratio determines the number of times inventory is converted into revenue from operations during the accounting period under consideration. Options : (A) I and II (B) II and III (C) III and IV (D) I and IV(OR)(b) Ratios that are calculated for measuring the efficiency of operations of business based on effective utilisation of resources are called : (A) Turnover ratios (B) Profitability ratios (C) Solvency ratios (D) Liquidity ratios
›Reveal solutionSolution
Part (a): statements I and IV are correct - option (D). Part (b): turnover ratios measure operating efficiency - option (A).
Part (a)
Statement Verdict Reason I - low current ratio risks short-term default Correct Current ratio = CA / CL; a low value means weak short-term solvency II - payables turnover = net credit sales / avg payables Incorrect It uses net credit purchases; sales are used for receivables turnover III - Operating profit ratio + Gross profit ratio = 100 Incorrect Operating profit = Gross profit - Operating expenses; they never sum to 100 IV - inventory turnover = times inventory converted to revenue Correct Inventory turnover = Cost of revenue / Average inventory - CBSE 2026Set 67/5/11 markMCQQ.(a) From the following information obtained from the books of accounts of Ananda Ltd., calculate ‘Quick Ratio’ of the company : Total Current Assets (including stock and prepaid expenses) ₹ 2,00,000; Stock ₹ 20,000; Prepaid expenses ₹ 10,000; Current liabilities ₹ 1,70,000. (A) 20 : 17 (B) 1 : 1 (C) 18 : 17 (D) 19 : 17(OR)(b) ‘Analysis of financial statements is useful and significant to different users.’ Which of the following users is concerned with a firm’s long-term solvency and survival ? (A) Labour unions (B) Trade payables (C) Finance manager (D) Lenders
›Reveal solutionSolution
(a) Quick Ratio of Ananda Ltd. = 1 : 1 → option (B).
(b) The user concerned with long-term solvency and survival is Lenders → option (D).
Part (a)
The Quick (Acid-Test) Ratio measures the ability to meet current liabilities from the most liquid assets, excluding Stock and Prepaid Expenses (which are not readily convertible to cash).
Quick Assets = Current Assets − Stock − Prepaid Expenses = 2,00,000 − 20,000 − 10,000 = ₹1,70,000 …
- CBSE 2026Set 67/5/11 markMCQQ.The following information is obtained from the books of Devdutt Ltd. : Working capital – ₹ 4,00,000 Trade Payables – ₹ 50,000 Other Current liabilities – ₹ 1,00,000 Current assets of Devdutt Ltd. are : (A) ₹ 2,50,000 (B) ₹ 4,50,000 (C) ₹ 5,00,000 (D) ₹ 5,50,000
›Reveal solutionSolution
The Current Assets of Devdutt Ltd. are calculated as ₹ 5,50,000 by using the working capital formula.
Understanding a company's liquidity position is crucial for assessing its short-term financial health. One of the primary tools for this assessment is Liquidity Ratio Analysis, which includes calculating ratios like the Current Ratio and the Quick Ratio, and also understanding key components like Working Capital.
Working Capital represents the excess of current assets over current liabilities. It indicates the funds available to a business for its day-to-day operations after meeting its short-term obligations. A positive working capital signifies that a company has enough current assets to cover its current liabilities, suggesting good short-term solvency.
The fundamental formula for Working Capital is:
Working Capital = Current Assets - Current Liabilities
In this question, we are given the Working Capital and the components of Current Liabilities. Our goal is to determine the Current Assets. We can rearrange the formula to solve for Current Assets:
Current Assets = Working Capital + Current Liabilities
Let's break down the calculation.
Working Notes
-
Calculation of Total Current Liabilities:
Current Liabilities are obligations that are expected to be settled within one year or the operating cycle of the business, whichever is longer.
- Trade Payables = ₹ 50,000
- Other Current Liabilities = ₹ 1,00,000 Total Current Liabilities = Trade Payables + Other Current Liabilities Total Current Liabilities = ₹ 50,000 + ₹ 1,00,000 = ₹ 1,50,000
-
Calculation of Current Assets:
Now that we have the total current liabilities and the working capital, we can find the current assets using the rearranged formula. …
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- CBSE 2026Set MARCH1 markQ.Will the current ratio increase or decrease when the current assets increase and the current liabilities remain unchanged?
›Reveal solutionSolution
If current assets rise and current liabilities stay the same, the current ratio increases.
Current Ratio = Current Assets / Current Liabilities.
When current assets increase and current liabilities are unchanged, the numerator becomes larger while the denominator is constant, so the value of the ratio rises.
…
- CBSE 2026Set ANNUAL1 markMCQQ.Gayatri Limited's current ratio is 0.5 : 1. What will the effect on the current ratio, if goods purchased for cash? A) Will increase B) Will decrease C) Cannot be determined D) No change
›Reveal solutionSolution
A cash purchase of goods leaves the current ratio unchanged - option (D).
Current ratio = Current Assets / Current Liabilities. When goods are bought for cash:
- Inventory (a current asset) increases.
- Cash (a current asset) decreases by the same amount.
The two effects cancel, so total current assets stay the same, and current liabilities are not affected at all. With both numerator and denominator unchanged, the ratio stays at 0.5 : 1.
…
- CBSE 2026Set ANNUAL1 markMCQQ.The ideal current ratio is(a) 1 : 1(b) 2 : 1(c) 1 : 2(d) 1.5 : 1
›Reveal solutionSolution
2:1 is the textbook "ideal" current ratio — ₹2 of current assets backing every ₹1 of current liabilities gives a comfortable safety margin for meeting short-term obligations.
The Current Ratio = Current Assets ÷ Current Liabilities, and it measures a firm's ability to meet its short-term obligations out of its short-term (current) resources.
A ratio of 2:1 has traditionally been regarded as the "ideal" or safe benchmark because:
- It implies the firm has twice as many current assets as current liabilities, providing a buffer even if some current assets (such as inventory) prove slow or difficult to convert into cash quickly, or if some current assets turn out to be partly unrealizable. …
- CBSE 2025Set 67/4/11 markMCQQ.The Quick Ratio of a company is 2 : 1. Which of the following transactions will result in decrease of this ratio ? (A) Payment of outstanding salary (B) Cash received from debtors (C) Sale of goods at a profit (D) Purchase of goods for cash
›Reveal solutionSolution
(D) Purchase of goods for cash decreases the Quick Ratio, because it converts a quick asset (cash) into inventory (not a quick asset) while current liabilities stay unchanged.
Concept: Quick Ratio
Quick Ratio=Current LiabilitiesQuick Assets
Quick assets = current assets − inventory − prepaid expenses (i.e. cash, marketable securities, debtors). Let quick assets =2x and current liabilities =x (ratio 2:1).
Effect of Each Transaction
(A) Payment of outstanding salary — a current liability paid in cash: both fall by the same amount y. New ratio =x−y2x−y. Since x−y2x−y−2=x−yy>0, the ratio rises above 2:1. (Paying a current liability improves a quick ratio that is above 1:1.)
(B) Cash received from debtors — cash up, debtors down; both are quick assets, so total quick assets and current liabilities are unchanged. Ratio unchanged.
(C) Sale of goods at a profit — quick assets rise (cash/debtors up), liabilities unchanged. Ratio rises. …
- CBSE 2025Set 67/5/11 markMCQQ.Operating ratio of a company is 63%. Its gross profit ratio is 20%. What will be its operating profit ratio ? (A) 37% (B) 23% (C) 43% (D) 83%(OR)Which of the following is not a purpose of analysis of financial statements ? (A) To assess the current profitability and the operational efficiency of the firm. (B) To ascertain the relative importance of different components of financial position of the firm. (C) To just study the reports of the company. (D) To judge the ability of the firm to repay its debt.
›Reveal solutionSolution
Part (a): Operating Profit Ratio = 100% − 63% = 37% — option (A). Part (b): (C) To just study the reports of the company.
Part (a)
The Operating Ratio measures operating cost as a percentage of revenue from operations, while the Operating Profit Ratio measures operating profit as a percentage of the same revenue. Since operating cost and operating profit together make up the whole of revenue from operations:
Operating Ratio + Operating Profit Ratio = 100%
Therefore:
Operating Profit Ratio = 100% − Operating Ratio = 100% − 63% = 37% …
- CBSE 2025Set MARCH1 markMCQQ.Which of the following is not included to compute current ratio?(a) Debtors(b) Stock(c) Bills receivables(d) Furniture
›Reveal solutionSolution
Current ratio = Current assets ÷ Current liabilities; debtors, stock and bills receivable are current assets, but furniture is a fixed asset and is excluded. Correct option: (d).
In GSEB Class-12 Commerce Accountancy (Accounting Ratios):
…
- CBSE 2025Set ANNUAL1 markQ.Find the value of current Assets from the following information - Current Ratio 2 : 1, Current Liability ₹ 5,00,000
›Reveal solutionSolution
Current Ratio 2 : 1 and Current Liabilities ₹5,00,000 give Current Assets = ₹10,00,000.
The current ratio relates current assets to current liabilities:
Current Ratio = Current Assets ÷ Current Liabilities
Particulars Amount Current Ratio 2 : 1 Current Liabilities ₹5,00,000 Current Assets = 2 × 5,00,000 ₹10,00,000 …
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