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 |
| (b) Reserves & Surplus | 9 | xxx |
| 2. Non-current Liabilities | | |
| (a) Long-term Borrowings | 10 | xxx |
| 3. Current Liabilities | | |
| (a) Trade Payables | 11 | xxx |
| (b) Short-term Borrowings | 12 | xxx |
| (c) Other Current Liabilities | 13 | xxx |
| (d) Short-term Provisions | 14 | xxx |
| Total Equity & Liabilities | | xxxx |
For ratio analysis, you only pick the current items from the above. Bank overdraft (if repayable on demand) is a current liability. Prepaid expenses are included in "Other Current Assets."
A Worked Example (from NCERT style)
Suppose a firm has:
- Current Assets: ₹4,00,000 (including Inventory ₹1,50,000 and Prepaid Expenses ₹20,000)
- Current Liabilities: ₹2,00,000
Current Ratio = ₹4,00,000 / ₹2,00,000 = 2:1 (ideal)
Quick Assets = ₹4,00,000 – ₹1,50,000 – ₹20,000 = ₹2,30,000
Quick Ratio = ₹2,30,000 / ₹2,00,000 = 1.15:1 (above ideal 1:1, so comfortable)
If the quick ratio were 0.8:1, the firm would struggle to pay urgent bills without selling inventory.
The Core Takeaway
Liquidity ratio analysis is a tool for decision-making, not a bookkeeping entry. It answers: Can the business pay its upcoming bills without selling its factory? The answer comes from the Balance Sheet, not from a journal. As a Class 12 student, you must be able to compute both ratios from a given Balance Sheet and comment on whether the firm is liquid or illiquid based on the 2:1 and 1:1 benchmarks.
In exam problems, always check if inventory and prepaid expenses are given separately. If not, assume they are included in current assets. For quick ratio, subtract them explicitly.