Accountancy · Ch 9 — Accounting Ratios
Liquidity Ratios
Liquidity Ratios
Liquidity ratios measure a firm's ability to meet its short-term obligations — debts that fall due within the next twelve months. This is called short-term solvency. The analysis focuses on two items from the Balance Sheet: current assets and current liabilities. Two ratios fall under this category: the current ratio and the liquidity ratio (also called the quick ratio or acid-test ratio).
Current Ratio
The current ratio compares total current assets to total current liabilities. It tells us whether the business has enough short-term assets to cover its short-term debts.
Current Ratio = Current Assets / Current Liabilities
Current assets include cash, bank balances, debtors (accounts receivable), bills receivable, short-term investments (marketable securities), inventory (stock), and prepaid expenses. Current liabilities include creditors (accounts payable), bills payable, outstanding expenses, short-term loans, bank overdraft, and provision for taxation (if treated as a current liability).
A current ratio of 2:1 is considered ideal. This means current assets are twice the current liabilities. A ratio lower than 2:1 may indicate difficulty in paying short-term debts. A ratio much higher than 2:1 may mean idle funds tied up in current assets, which is not efficient.
Liquidity Ratio (Quick Ratio / Acid-Test Ratio)
This is a stricter measure of short-term solvency. It excludes inventory and prepaid expenses from current assets because inventory may not be quickly convertible into cash, and prepaid expenses cannot be used to pay liabilities.
Liquidity Ratio = Liquid Assets / Current Liabilities
Liquid assets = Current Assets – (Inventory + Prepaid Expenses)
Liquid assets include cash, bank, debtors, bills receivable, and short-term investments. A liquidity ratio of 1:1 is considered satisfactory. This means liquid assets are exactly equal to current liabilities. A ratio lower than 1:1 may signal a liquidity problem.
The current ratio is a broader measure; the liquidity ratio is a stricter, more conservative test. Both are used together to assess short-term financial health.
Accounting Treatment
These ratios are calculated from the Balance Sheet. No journal entry is involved — they are purely analytical tools. The values for current assets and current liabilities are taken directly from the Balance Sheet. For example, if the Balance Sheet shows: …