Liquidity Ratios and Solvency Ratios

Liquidity Ratios — short-term debt-paying ability

Current Ratio = Current Assets ÷ Current Liabilities

Current Assets = Cash + Bank + Debtors + Bills Receivable + Stock + Prepaid Expenses + short-term investments. Current Liabilities = Creditors + Bills Payable + Outstanding Expenses + Bank Overdraft + other short-term liabilities. The Current Ratio measures whether the firm holds enough current assets, in total, to cover its current liabilities; 2:1 is conventionally treated as a comfortable benchmark, though the level actually considered ideal varies by industry.

Quick (Liquid) Ratio = Quick Assets ÷ Current Liabilities, where Quick Assets = Current Assets − Stock − Prepaid Expenses

Stock and Prepaid Expenses are excluded because Stock must first be SOLD (and the amount collected) before it becomes cash, and Prepaid Expenses can never be converted into cash at all — they represent only a future service already paid for. The Quick Ratio is therefore a stricter, more immediate test of liquidity than the Current Ratio; 1:1 is conventionally treated as satisfactory.

Solvency Ratios — long-term debt-paying ability

Debt-Equity Ratio = Long-term Debt (external equity) ÷ Shareholders' Fund (internal equity)

Shareholders' Fund (also called Proprietors' Fund or Net Worth) = Equity Share Capital + Preference Share Capital + Reserves and Surplus, less any fictitious assets or accumulated losses. This ratio shows the proportion in which the business is financed by OUTSIDE long-term lenders versus the OWNERS' own funds — a lower ratio generally looks safer to a long-term lender, since owners then bear a larger share of the risk.

Proprietary Ratio = Shareholders' Fund ÷ Total Assets

This shows what proportion of the firm's TOTAL assets has been financed by the owners themselves, as opposed to outside long-term or current liabilities — a higher Proprietary Ratio signals stronger long-term financial stability, since a larger cushion of owners' own money stands behind the firm's assets.