LIQUIDITY RATIOS

The ratios that are used to test the liquidity position of a firm are called liquidity
ratios.

Liquidity refers to the ability of a firm in settling its current liabilities as and when they
become due. It is also known as short-term solvency.

1) Current Ratio
2) Quick Ratio
3) Super –quick Ratio

(1) Current Ratio = 2:1

Current ratio establishes relationship between current assets and current liabilities.
Current assets are those assets that can be converted into cash say within a year. And, current
liabilities are those liabilities that should be settled within a short period say one year.

Current Assets
Current ratio 
Current Liabilities

Current Ratio = Current assets: Current liabilities

(Current Ratio of 2: 1 is considered ideal )

Current ratio is also known as working capital ratio as the excess of current assets
over current liabilities is called working capital.

Current Assets Current Liabilities

1) Cash in hand/ Cash at bank 1) Outstanding expenses (accrued expenses)
2) Marketable securities 2) Bills Payable
3) Temporary investments 3) Sundry creditors
4) Bills Receivable 4) Short-term loans and advances
5) Sundry Debtors 5) Income –tax Payable
6) Inventories (Stocks) 6) Dividends Payable
7) Short –term loans and advances 7) Income Received in advance
8) Outstanding incomes /(accrued incomes) 8) Bank overdraft.
9) Prepaid expenses.
 • Bank overdraft should be excluded from current liabilities when it is a permanent
or long-term arrangement with the bank.

Illustration: 1
Calculate current ratio from the following:

Rs. Rs.
Sundry debtors 1, 00,000 Outstanding salaries 20,000
Bills receivable 80,000 Prepaid expenses 2,000
Stock 50,000 Marketable securities 20,000
Sundry creditors 80,000 Bank Overdraft 30,000
Bills Payable 40,000 Cash in hand and at bank 1, 00,000

Solution: 
Current Assets
Current ratio 
Current Liabilities
3, 52, 000
  2.70 or 207% or 2.07:1
1, 70, 000

Current Assets = 1, 00,000 + 80,000+ 50,000 + 2,000 + 20,000 + 1, 00,000

= Rs. 3, 52,000

Current Liabilities = 80,000+ 40,000 + 20,000 + 30,000

= Rs. 1,70,000
= 2.07 or 207% or 2.07:1

Interpretation of Current Ratio

As it is stated earlier, no interpretation is possible without analysis and analysis
becomes useless without interpretation. Therefore, in ratio analysis, interpretation is of great
importance and in interpreting a ratio standard norm or rule of thumb is of great use. In the
case of current ratio, the standard norm or rule of thumb is 2:1. It means that let the total
amount of current assets be twice of the total amount of current liabilities. When a firm‟s
current ratio is 2 or more it means that its liquidity position is considered to be sound or good.

(2) Quick Ratio = 1:1

• Quick Ratio or Liquid Ratio or Acid Test Ratio
Quick ratio is a more rigorous test of liquidity than the current ratio. Quick ratio
establishes relationship between quick assets and current liabilities. Quick assets are those
assets which could be easily and quickly converted into cash within a short period without
loss of value.

Quick Assets
Quick ratio =
Quick Liabilities

QA = CA –(Stock + PP Exp)

QL= CL-Bank Overdrafts

(A Quick Ratio of 1:1 is considered satisfactory )

Illustration: 2
From the following figures, calculate quick ratio:
Short-term investments 50,000
Sundry Debtors 80,000
Stock 1,00,000
Bills Receivable 60,000
Sundry Creditors 50,000
Bills Payable 30,000
Bank overdraft 40,000
Prepaid expenses 10,000
Outstanding expenses 10,000
Cash in hand and at bank 60,000
Short-term loan (cr.) 70,000

Solution:
Quick Assets
Quick ratio =
Quick Liabilities

Quick assets = Current assets except or Minus stock and prepaid expenses
Quick assets
= Rs. 50,000 + 80,000 + 60,000 + 60,000
= Rs. 2, 50,000

Current Liabilities = Rs. 50,000 + 30,000 + 40,000 + 10,000 + 70,000

= Rs. 2, 00,000
2,50,000
Quick ratio =  1.25 or 12% or 1.25:1
2,00,000
Alternate way of arriving at quick or liquid ratio:
Some authors are of the opinion that in arriving at quick ratio, the amount of quick
assets is to be compared with quick liabilities not with current liabilities. And, as such quick
ratio can be found out with the help of the following formula:

Quick Assets
Quick ratio =
Quick Liabilities

Quick Liabilities = Current Liabilities – Bank overdraft

Considering this alternative way, quick ratio as for as illustration 2 is given below:

Quick Assets
Quick ratio =
Quick Liabilities

Quick Assets = Rs. 2,50,000

Quick Liabilities = Current liabilities – Bank overdrafts

= Rs. 2,00,000 – Rs. 40,000
= Rs. 1,60,000
Rs.2,50,000
Quick Ratio =  1.56
Rs.1,60,000

Note: Bank overdraft is not included in quick liabilities since it is made as a permanent
arrangement with the bank in general.

Interpretation of Quick Ratio

In general, a high liquid ratio (quick ratio) indicates that the firm is so sound as
regards its liquidity is concerned whereas a low liquid/quick ratio indicates that the firm‟s
liquidity position is not good.

Ideal Quick Ratio or Standard norm for quick ratio

The ideal quick ratio or the standard norm for quick ratio is 1:1 When a firm‟s quick
ratio is greater than this rule of thumb called 1:1, then the firm‟s liquidity position is said to
be sound or good. However, a quick ratio of 1:1 does not necessarily mean sound liquidity
position if all the debtors cannot be realized and when much cash is required to meet the
current obligations.

Significance of Quick Ratio

The quick ratio is very much useful in measuring a firm‟s liquidity position. It
measures a firm‟s ability to pay off current obligations when they become due. As stated
earlier, this is a more rigorous test of liquidity than the current ratio as it is used as a
complementary ratio to the current ratio.
(3) Super Quick Ratio or Absolute Liquid Ratio = 0.5:1
It is true that debtors, bills receivables are more liquid than stock. Nevertheless, there
may be doubts regarding their realization into cash immediately or in time. Hence, some
authorities are of the opinion that super quick ratio (Absolute Quick Ratio) should also be
calculated along with the earlier two ratios namely current ratio and quick ratio so as to
establish relationship between super quick assets and current liabilities.

Super quick ratio establishes the relationship between super quick assets and current
liabilities.

Super quick assets are cash in hand, cash at bank and marketable securities or
temporary investments. As the name implies, marketable securities or temporary investments
or investment in Govt. securities are encashable very quickly. Therefore, Marketable
securities are included under super quick assets.

A Super Quick Ratio of 0.5:1 is satisfactory

Illustration: 3
From the given below accounting figures, calculate super quick ratio:
Rs. Rs.
Cash in hand 50,000 Sundry creditors 2,80,000
Cash at bank 1,00,000 Bills payable 40,000
Marketable securities 2,00,000 Outstanding expenses 20,000
Sundry debtors 1,20,000 Short term Loan (cr.) 80,000
Bills receivables 80,000 Accrued income 10,000
Stock 1,50,000 Bank overdraft 1,20,000
Prepaid expenses 20,000

Solution:
Absolute Liquid Assets
Super Quick Ratio or Absolute Liquid Ratio =
Current Liabilities

Super Quick Assets = Rs. 50,000 + 1,00,000 + 2,00,000

= Rs. 3,50,000

Current Liabilities = Rs. 2,80,000 + 40,000 + 20,000 + 80,000 + 1,20,000

= Rs. 5,40,000
3,50,000
Super Quick Ratio =
5,40,000

= 0.65 or 65% or .65:1

Interpretation of Absolute liquid Ratio
The standard norm of absolute liquid ratio is .5:1 or 50%. The point is that when a
firm has super quick assets to the tune of 50% of its current liabilities, it is said to be sound as
far as its liquidity position is concerned.

Absolute liquid ratio and super quick ratio is also known as cash ratio.

Sl.No Liquidity Ratios Formula Standard Norm

1. Current Ratio Current Assets 2:1 or 200%
Current Liabilities

2. Quick Ratio Quick Assets 1:1 or 100%

Quick Liabilities

3. Super Quick Ratio Absolute Liquid Assets 0.5:1 or 50%

Current Liabilities

Illustration:4
The following is the Balance Sheet of New Bharath Limited for the year ending 31st
Dec 2009.

Liabilities Rs. Assets Rs.

Equity share capital 5,00,000 Fixed assets 10,00,000
Preference share 1,00,000 Investments 3,00,000
Capital
Reserves & Surplus 4,00,000 Current assets :
Debentures 7,00,000 Cash 50,000
Current liabilities Debtors 1,50,000
Sundry creditors 60,000 Marketable securities 2,00,000
Bills payable 1,00,000 Stock 3,00,000
O/S expenses 10,000
Bank overdraft 1,30,000
20,00,000 20,00,000
From the above balance sheet, ascertain:
(a) Current ratio (b) Quick ratio (c) Absolute liquid ratio Comment on these ratios.

Solution:
Current Assets 7, 00, 000
(a) Current ratio =   2.33 : 1
Current Liabilities 3, 00, 000
 Ratio Analysis 3.11
Rs.
Current assets:
Cash 50,000
Debtors 1,50,000
M. Securities 2,00,000
Stock 3,00,000
7,00,000

Rs.
Current liabilities:
S. Creditors 60,000
Bills Payable 1,00,000
O/S Expenses 10,000
Bank Overdraft 1,30,000
3,00,000

Quick or Liquid Assets 4, 00, 000

(b) Quick or Acid Test ratio    1.33 :1
Current Liabilities 3, 00, 000
Quick Assets = Current Assets – Stock
= 7,00,000 – 3,00,000 = Rs.4,00,000
AbsoluteLiquid Assets 2,50, 000
(c) Absolute Liquid ratio =   0.83 : 1
Current Liabilities 3, 00, 000
Absolute liquid assets: Rs.
Cash 50,000
Marketable Securities 2,00,000
2,50,000
Comments:
Current ratio is satisfactory because the actual CR of 2.33 is higher than the accepted
standard current ratio of 2:1. Similarly, the Acid test ratio, 1.33 and Absolute liquid ratio 0.83
are also quite higher than the accepted standards of 1 and 0.5 respectively. In all, the liquidity
position of the company is sound.

Illustration: 5
Following information is given to you:
(i) Current Ratio = 2.5

(ii) Working Capital= Rs.90,000

Find out: (a) Current Assets, and (b) Current Liabilities

 Ratio Analysis 3.12

Solution:

(1) Current Assets:

Cr. Assets
Current Ratio = = 2.5.1
Cr. Liabilities

Cr Assets – Cr Liabilities = Working Capital

2.5 – 1 = 1.5

If working capital is 1.5, Cr assets are 2.5

90, 000
If Working Capital is Rs 90,000, Cr Assets are   2.5
1.5

Cr Assets =2 Rs 1,50,000

(2) Current Liabilities

If working capital is 1.5, Cr liabilities are 1
90, 000
If working capital is Rs 90,000, Cr Liabilities are  1
1.5

Cr Assets = Rs 60,000

Illustration: 6
The Following information of a company is given:
Current Ratio 2.5:1; Acid-test ratio 1.5:1; Current liabilities Rs.50,000. Find out:
a) Current Assets
b) Liquid Assets/ quick Assets
c) Inventory

Solution:

Current Assets
Current Ratio =
Current Liabilities

Current Assets
2.5 =
Rs.50,000

(a) Current Assets = 50,000  2.5 = Rs. 1,25,000

 Ratio Analysis 3.13
Liquid Assets
Acid-test Ratio 
Current Liabilities

Liquid Assets
1.5 
Rs.50,000

(b) Liquid Assets = 50,000  1.5 = Rs. 75,000

(c) Inventory = Current Assets – Liquid Assets

= Rs. 1,25,000 – RS. 75,000

= Rs. 50,000

Current Assets = Rs. 1,25,000

Liquid Assets = Rs. 75,000
Inventory = Rs. 50,000

Illustration: 7
Given:
Current Ratio = 2.8; Acid-Test Ratio = 1.5; Working Capital = Rs. 1,62,000
Find out:
a) Current Assets
b) Current Liabilities
c) Liquid Assets

Solution:

Let current Liabilities be X.

Working Capital = Current Assets – Current liabilities

Rs. 1,62,000 = 2.8X – 1.0X

Rs. 1,62,000 = 1.8 X

1,62,000
Or, X (Current Liabilities) = = Rs.90,000
1.8

Current Assets = 90,000  2.8 = Rs. 2,52,000

Liquid Assets
Acid-test Ratio 
Current Liabilities
 Ratio Analysis 3.14

Liquid Assets
1.5 
Rs. 90,000

Liquid Assets = 90,000  1.5 = Rs. 1,35,000

Current Assets : Rs. 2,52,000

Current Liabilities : Rs. 90,000
Liquid Assets : Rs. 1,35,000.

Illustration: 8
Current liability of a company is Rs.3, 00,000. If Current ratio is 3:1 and Quick ratio
is 1:1, Calculate value of stock.

Solution : 

Current Assets
Current ratio 
Current Liabilities

Current Assets
3
Rs. 3,00,000

Current Assets = Rs. 9,00,000

It is given in the problem that current liability is Rs.3,00,000. Therefore, current assets
must be Rs.9,00,000 i.e. 3 times current liabilities as current ratio is 3:1.
Liquid Assets
Liquid Ratio =
Current Liabilities

Liquid Assets
1=
3,00,000

Liquid Assets = Rs. 3,00,000

Liquid ratio as given in the problem is 1:1. Therefore, when current liability is
Rs.3,00,000, the liquid assets must also be Rs.3,00,000.
Stock = Current Assets – Liquid Assets
= 9,00,000 – 3,00,000
Stock = Rs. 6,00,000
 Ratio Analysis 3.15
Illustration 9:
The working capital position of ABC Co. Ltd stands as under on 31.12.99.
Current Liabilities Rs. Current Assets Rs.
Sundry Creditors 4,50,000 Cash 1,00,000
Bank Overdraft 2,50,000 Debtors 5,00,000
Stock 4,50,000
Bills Receivable 50,000
7,00,000 11,00,000
(i) Calculate current ratio and quick ratio from the above information.
(ii) Calculate the revised current ratio and quick ratio assuming that Bank overdraft of
Rs.1,00,000 is discharged during the year.
(iii) Calculate current ratio and quick ratio when the book-debts were bad to the extent
of 20%.
Solution:
Current Assets
(1) (a) Current Ratio =
Current Liabilities
11, 00, 000
  1.57
7, 00, 000
Liquid Assets
(b) Quick Ratio =
Current Liabilities
Current Assets  Stock
=
Current Liabilities
11,00,000  4,50, 000 6,50, 000
   0.92
7,00,000 7, 00, 000
11, 00, 000
(2) (a) Revised Current Ratio 
7,00,000 1, 00, 000

11, 00, 000

  1.83
6, 00, 000
6,50, 000
(b) Revised Quick Ratio   1.08
6, 00, 000
11, 00, 000 1, 00, 000
(3) (a) Current Ratio   1.42
7, 00, 000

5,50, 000
(b) Quick Ratio   0.78
7, 00, 000
 Ratio Analysis 3.16

Working:
Total Current assets 11, 00,000
Less: Stock 4,50,000
Bad debts @ 20% of 5,00,000 1,00,000 5,50,000
∴Quick assets 5, 50,000

Illustration: 10
Calculate (i) current Assets,(ii) liquid asset and (iii) current liabilities when the
current ratio is 2.5, liquid ratio is 1.5, stock Rs. 67,500 and prepaid expenses Rs.2,500.

Solution:

(a) Current Assets

Stock & Prepaid expenses = Current assets – Liquid Assets
= 2.5 – 1.5
Stock & Prepaid expenses = 1
When stock & Prepaid expenses (1.0) = Rs. 70,000 (67,500+2,500)
Current Assets (2.5) =?

2.5
(b) Liquid Assets   70, 000  Rs.1, 75, 000
1
Liquid Assets = Current Assets – Stock & Prepaid Expenses
1,05,000 = 1,75,000 – 70,000

(c) Current Liabilities

When Current Assets (2.5) = Rs. 1,75,000
Current Liabilities =?
1.0
 1, 75, 000  70, 000
2.5

Illustration: 11
The following information of a company is given: Current ratio 2.2; Liquid ratio 1.2;
Current liability Rs.75,000 and prepaid expenses – nil.

Find out (a) Current assets (b) Liquid assets and (c) Inventory
 Ratio Analysis 3.17
Solution:
Current Assets 7, 00, 000
(a) Current Assets =   2.33
Current Liabilities 3, 00, 000
It is given that current liabilities are Rs. 75,000
∴ If Current Liabilities (1.0) = Rs. 75,000
Current Assets (2.2) =?
2.2
  75, 000  Rs.1, 65, 000
1.0

Liquid Assets
(b) Liquid Ratio = = 1.2
Current Liabilities
 ∴ If Current Liabilities (1.0) = Rs.
Ratio Analysis 3.18
75,000Liquid Assets (1.2) =?
Solution:
1.2
  75, 000  Rs.90, 000
1.0

(c) Inventory

Inventory & Prepaid Expenses = Current Assets – Liquid Assets

= 1,65,000 – 90,000
∴ Inventory = Rs. 75,000