Q.Point out two reasons for increase in working capital.
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🔒 Start your 14-day free trial to unlock the full solution →Concept understanding — Liquidity Measurement Ratios
Let’s start with something you already know. Suppose you have ₹500 in your pocket, and you need to pay ₹200 for a book today. You can easily do it — you have enough cash. That’s liquidity: your ability to meet short-term payments as they fall due.
Now imagine a business. It has to pay salaries next week, pay its suppliers in 15 days, and maybe repay a bank loan in 3 months. To survive, it must have enough cash or assets that can be quickly turned into cash. That’s where liquidity measurement ratios come in.
What Are Liquidity Ratios?
Liquidity ratios are financial tools that measure a company’s ability to pay off its short-term liabilities (debts due within one year) using its short-term assets (assets that can be converted into cash within one year). The two most important ones in your Class 12 syllabus are:
- Current Ratio
- Quick Ratio (also called Acid-Test Ratio)
Both are calculated from the Balance Sheet — specifically from the side that shows assets and liabilities.
Why Do They Matter?
A business might be profitable on paper but still fail if it cannot pay its bills on time. Liquidity ratios tell us whether the company is financially healthy in the short run. Lenders, suppliers, and investors all look at these ratios before giving credit or investing.
A high ratio means safety (more assets than liabilities), but too high may mean idle cash. A low ratio signals risk of default.
1. Current Ratio
Formula (from NCERT):
Current Ratio = Current Assets / Current Liabilities
What it tells you: For every ₹1 of short-term debt, how many rupees of short-term assets does the company have?
Ideal benchmark: 2:1 (i.e., current assets should be twice current liabilities). This is a rule of thumb, not a law.
Example (NCERT-style):
If Current Assets = ₹4,00,000 and Current Liabilities = ₹2,00,000, then Current Ratio = 4,00,000 / 2,00,000 = 2 : 1.
What are Current Assets?
Cash, bank, debtors (accounts receivable), bills receivable, inventory (stock), prepaid expenses, short-term investments.
What are Current Liabilities?
Creditors (accounts payable), bills payable, outstanding expenses, short-term loans, bank overdraft, provision for tax.
Inventory is included in current assets, but it may not be quickly convertible to cash. That’s why we also use the Quick Ratio.
2. Quick Ratio (Acid-Test Ratio)
Formula (from NCERT):
Quick Ratio = Quick Assets / Current Liabilities
Where Quick Assets = Current Assets – Inventory – Prepaid Expenses
Why remove inventory and prepaid expenses?
Inventory may take time to sell, and prepaid expenses cannot be turned into cash. Quick assets are the most liquid — cash, debtors, bills receivable, short-term investments.
Ideal benchmark: 1:1
Example:
If Current Assets = ₹4,00,000, Inventory = ₹1,00,000, Prepaid Expenses = ₹20,000, and Current Liabilities = ₹2,00,000, then:
Quick Assets = 4,00,000 – 1,00,000 – 20,000 = ₹2,80,000
Quick Ratio = 2,80,000 / 2,00,000 = 1.4 : 1
Accounting Treatment — Where Do These Numbers Come From?
Liquidity ratios are not journal entries. They are calculated from the Balance Sheet. No account is debited or credited for the ratio itself. But the underlying transactions that create current assets and liabilities are recorded through normal journal entries.
For example:
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When goods are sold on credit:
Debit Debtors A/c, Credit Sales A/c
(This increases current assets — debtors)
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When goods are purchased on credit:
Debit Purchases A/c, Credit Creditors A/c
(This increases current liabilities — creditors)
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When salary is due but not paid:
Debit Salary A/c, Credit Outstanding Salary A/c
(This increases current liabilities)
So the ratio itself is a derived figure — it summarises the net effect of many such entries.
Format / Proforma (as per NCERT) …
Working capital rises when current assets grow faster than current liabilities, typically funded from long-term sources. …
Working capital rises mainly when a firm brings in long-term funds that boost current assets or pay off current liabilities.
Working Capital = Current Assets − Current Liabilities. It increases whenever current assets rise without a matching rise in current liabilities, or current liabilities fall without a matching fall in current assets. Two common reasons:
- Raising long-term finance utilised for current purposes — e.g. issue of equity/preference shares or debentures for cash, or raising a long-term loan, where the cash so raised either increases current assets (cash/bank balance) or is used to repay a current liability — in either case, working capital increases because a long-term source has funded a current need. …
Showing the 12 most recent of 37 on this concept.
- CBSE 2026Set MARCH1 markQ.What is indicated by liquidity ratios?
›Reveal solutionSolution
Liquidity ratios show a firm's ability to meet its short-term obligations.
Liquidity ratios (such as the current ratio and the quick/liquid ratio) measure whether a firm has enough short-term resources to pay off its short-term dues as they fall due.
They indicate:
- the short-term solvency and financial strength of the firm,
- whether current assets are sufficient to cover current liabilities, and …
- CBSE 2026Set ANNUAL1 markMCQQ.The _______ is useful in evaluating Credit and collection policies.(a) Average payment period(b) Average collection period(c) Inventory holding period(d) Revenue from operation(a) Average payment period(b) Average collection period(c) Inventory holding period(d) Revenue from operation
›Reveal solutionSolution
Average Collection Period is useful in evaluating credit and collection policies (Option B).
The Average Collection Period (derived from the Trade Receivables Turnover Ratio, as 365/Turnover Ratio or 12 months/Turnover Ratio) measures the average time taken to collect dues from debtors/trade receivables. A shorter period indicates prompt collection and efficient credit policies, while a longer period may signal too liberal a credit policy or weak collection efforts. It is therefore the most direct and useful tool for evaluating a firm …
- CBSE 2025Set 67/5/11 markMCQQ.Ratios that are calculated for measuring the efficiency of operations of business based on effective utilisation of resources are called : (A) Activity Ratios (B) Profitability Ratios (C) Solvency Ratios (D) Liquidity Ratios
›Reveal solutionSolution
Ratios that measure the efficiency of operations based on effective utilisation of resources are called Activity Ratios.
Understanding the different categories of financial ratios is crucial for analysing a business's performance from various perspectives. Each category focuses on a specific aspect of the business. The question asks for ratios that measure the "efficiency of operations of business based on effective utilisation of resources." Let's break down what this means and how it relates to the given options.
"Efficiency of operations" refers to how well a business uses its assets and resources to generate revenue or output. "Effective utilisation of resources" implies getting the most out of what the business owns, such as inventory, debtors, or fixed assets.
Let's examine each option:
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A) Activity Ratios: Also known as Turnover Ratios, these ratios measure how efficiently a company is utilising its assets to generate sales. They indicate the speed at which assets are converted into sales or cash. For example, the Inventory Turnover Ratio shows how many times inventory is sold and replaced during a period, reflecting the efficiency of inventory management. A higher ratio generally indicates better efficiency. Similarly, Debtors Turnover Ratio measures how quickly a company collects its receivables. These ratios directly address the efficiency of operations and the effective utilisation of resources like inventory, debtors, and fixed assets.
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B) Profitability Ratios: These ratios measure a company's ability to generate profit from its sales, assets, or equity. Examples include Gross Profit Ratio, Net Profit Ratio, and Return on Investment. While profit is an outcome of efficient operations, profitability ratios primarily focus on the amount of profit generated relative to sales or investment, rather than the efficiency of resource conversion itself. …
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- CBSE 2025Set ANNUAL1 markMCQQ.Which of the following items is not taken into consideration while computing current ratio ? (A) Creditors (B) Debtors (C) Furniture (D) Bank overdraft
›Reveal solutionSolution
Furniture, being a fixed asset, is not used in computing the current ratio, so the answer is (C).
The current ratio compares current assets with current liabilities: Current Ratio = Current Assets / Current Liabilities. Only items realisable or payable within a year enter the formula.
- Debtors (B) are a current asset.
- Creditors (A) and Bank overdraft (D) are current liabilities. …
- CBSE 2025Set ANNUAL1 markMCQQ.Liquid assets include (A) Bills Receivable (B) Debtor (C) Cash (D) All of these
›Reveal solutionSolution
Bills receivable, debtors and cash are all liquid assets, so the answer is (D).
Liquid assets (also called quick assets) are current assets that can be turned into cash quickly, i.e. current assets excluding inventory/stock and prepaid expenses.
- Cash (C) is the most liquid asset of all.
- Debtors (B) are expected to be collected shortly.
- Bills Receivable (A) can be discounted or collected on maturity. …
- CBSE 2025Set ANNUAL1 markMCQQ.Current assets include only those assets which are expected to be realised within (A) 3 months (B) 6 months (C) 1 year (D) 2 years
›Reveal solutionSolution
Current assets are those realisable within one year (or the operating cycle), so the answer is (C).
In BSEB Inter / Bihar Class-12 Accountancy, following the NCERT/CBSE classification, a current asset is one that is expected to be realised in cash, sold or consumed within twelve months from the balance sheet date (or within the normal operating cycle).
- Examples: cash, debtors, bills receivable, stock, prepaid expenses. …
- CBSE 2025Set ANNUAL1 markMCQQ.If working capital is Rs. 1,80,000, Total liabilities Rs. 3,90,000, Non-current liabilities Rs. 3,00,000, Current ratio will be (A) 2 : 1 (B) 3 : 1 (C) 4 : 1 (D) 1 : 2
›Reveal solutionSolution
The current ratio is 3 : 1 — option (B).
Step 1 - Current Liabilities:
Current Liabilities = Total Liabilities - Non-current Liabilities = 3,90,000 - 3,00,000 = Rs. 90,000.
Step 2 - Current Assets:
Working Capital = Current Assets - Current Liabilities, so
Current Assets = Working Capital + Current Liabilities = 1,80,000 + 90,000 = Rs. 2,70,000. …
- CBSE 2025Set ANNUAL1 markMCQQ.Liquid assets =(a) Current Assets + Stock(b) Current Assets – (Inventory + Prepaid Expense)(c) Current Assets – Current Liabilities(d) Current Assets + (Depreciation + Inventory)
›Reveal solutionSolution
Liquid Assets = Current Assets minus Inventory and Prepaid Expenses — i.e., only the current assets that can be converted into cash quickly, without a time lag.
Not all current assets are equally 'liquid'. Current assets include cash, bank, debtors, bills receivable, short-term investments, inventory (stock), and prepaid expenses. Of these:
- Inventory/Stock needs to first be SOLD (and often the sale proceeds collected) before it becomes cash — this takes time and carries risk (it may not sell at book value), so it is excluded from 'liquid assets'.
- Prepaid expenses (like prepaid insurance/rent) represent a service already paid for in advance — they can NEVER be converted into cash; they are consumed over time, not realised. …
- CBSE 2025Set ANNUAL1 markMCQQ._____________helps to assess the short term solvency of a business.(a) Turnover ratio(b) Solvency ratio(c) Liquidity ratio(d) Profitability ratio
›Reveal solutionSolution
Liquidity ratios assess short-term solvency.
Accounting ratios are grouped by purpose: Liquidity ratios (Current Ratio, Quick Ratio) measure the ability to meet short-term obligations; Solvency ratios (Debt-Equity Ratio, Total Assets to Debt Ratio, Interest Coverage Ratio) measure long-term financial stability/ability to meet long-term debt; Turnover (activity) ratios (Inventory Turnover, Debtors Turnover) measure how efficiently resources are used; Profitability ratios (Gross Profit Ratio, Net Profit Ratio) measure earning perf …
- CBSE 2024Set 67/1/11 markMCQQ.Analysis of Financial Statements is useful and significant to different users. Which of the following users is particularly interested in the firm's ability to meet their claims over a very short period of time ? (A) Labour Unions (B) Trade Payables (C) Top Management (D) Finance Manager(OR)___________ ratios are calculated to determine the ability of the business to service its debt in the long run. (A) Liquidity (B) Turnover (C) Solvency (D) Profitability
›Reveal solutionSolution
Part (a): (B) Trade Payables. Part (b): (C) Solvency.
Part (a)
The question asks which user is most interested in the firm's ability to meet claims over a very short period — i.e. its liquidity.
- (A) Labour Unions — focus on job security, wages and long-term viability, not short-term settlement of claims.
- (B) Trade Payables — suppliers/creditors whose dues fall due within 30–90 days; their own recovery depends directly on the firm's short-term solvency, so they are the most interested. ✓
- (C) Top Management — interested in all aspects (liquidity, solvency, profitability, efficiency), not specifically short-term claims. …
- CBSE 2024Set MARCH1 markMCQQ.To arrive at liquid assets which of the following is deducted from current assets?(a) Stock(b) Cash and cash equivalent(c) Debtors(d) Bills receivables
›Reveal solutionSolution
Stock is deducted from current assets to get liquid assets, so option (a) is correct.
In this GSEB Class-12 Commerce ratio topic, liquid (quick) assets are those current assets readily convertible into cash. Stock/inventory is excluded because it must first be sold (and the receivable then collected) before it becomes cash; prepaid expenses are also excluded.
…
- CBSE 2024Set ANNUAL1 markMCQQ.Quick Assets = ?(a) Current Assets – Prepaid Expenses.(b) Current Assets + Inventory – Prepaid Expenses.(c) Current Assets – Inventory + Prepaid Expenses.(d) Current Assets – Inventory – Prepaid Expenses.
›Reveal solutionSolution
Quick Assets = Current Assets − Inventory − Prepaid Expenses — option (d).
Quick (or liquid) assets are those current assets that can be converted into cash almost immediately to meet current liabilities. Two current assets fail this test and are deducted:
- Inventory (stock) — must first be sold before it becomes cash.
- Prepaid Expenses — cannot be converted into cash at all (they will be consumed as services). …
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