Q.What are liquidity ratios? Discuss the importance of current and liquid ratio.

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:

1. Current Ratio
2. 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.

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.

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:

• When goods are sold on credit:

  Debit Debtors A/c, Credit Sales A/c

  (This increases current assets — debtors)

• When goods are purchased on credit:

  Debit Purchases A/c, Credit Creditors A/c

  (This increases current liabilities — creditors)

• 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)

The Balance Sheet is where you find the data. Here’s a simplified format showing only the relevant items:

From this:

• Current Ratio = 3,60,000 / 2,00,000 = 1.8 : 1
• Quick Assets = 3,60,000 – 1,00,000 – 20,000 = ₹2,40,000
• Quick Ratio = 2,40,000 / 2,00,000 = 1.2 : 1

Key Takeaways for Exams

• Current Ratio = Current Assets / Current Liabilities (ideal 2:1)
• Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities (ideal 1:1)
• Both are Balance Sheet ratios — no journal entry for the ratio itself.
• Always use absolute amounts from the Balance Sheet, not percentages.
• NCERT does not prescribe a single “correct” ideal — it says “generally accepted” norms.

Final Answer:

Liquidity ratios (Current Ratio and Quick Ratio) measure a firm’s short-term solvency. They are calculated from the Balance Sheet using current assets and current liabilities. No account is debited or credited for the ratio; it is a derived metric. The ideal current ratio is 2:1 and quick ratio is 1:1, but these are guidelines, not rules.