Liquidity is a prerequisite for the survival of the firms and is the ability of a firm to meet the short-term obligations when they become due. Liquidity ratio is helpful in determining the financial performance in terms of the credibility of the firms. When a firm quickly converts its current assets into cash in order to pay off its short-term obligations or current liabilities that firm would reflect the short-term financial strength.
Liquidity ratios are the tools of financial analysis that affects credit rating of the firms. Any firm consistently defaults its repayment that would affect the solvency and financial stability of the firms. With the help of liquidity ratios, it can be easily analyzed the availability of cash level of a firm because it measures how easily a company can convert its assets into cash. The rationale is the higher the ratio, the greater the pay off abilities of the firms.
The following ratios indicate the liquidity position of the firms as under:
It indicates the excess of current assets than current liabilities. Current ratio shows the relationship between a large amount of current assets & a small amount of current liabilities, which will be paid timely.
- Current assets are those assets which are converted into cash within one year, like, raw material, cash at bank, marketable securities, and finished goods.
- Current Liabilities are those liabilities which are due within one year, like, trade creditors & outstanding expenses, and bill payable.
Generally, 2:1 is considered as the ideal ratio for financially sound companies i.e. the current assets are just double their current liabilities. The rationale behind this ratio is the higher value would consider more satisfactory in terms of liquidity of firms’ ability to pay off the obligations on time.
ABC Company has Rs.600, 000 Current assets & Rs.200, 000 as current liabilities, and then the current ratio is 3:1. Obviously higher the ratio is good for meeting short-term obligations.
- It assesses the liquidity of the company.
- It represents the working capital status of the company.
- It indicates the margin of safety.
- It provides the idea of short-term solvency of the company.
- The accuracy of this ratio varies with industry to industry & from business to business.
- It measures the liquidity on a quantity basis, not a quality basis.
- Over-valuation of stock is also affected the accuracy of this ratio.
Quick/ Acid Test Ratio
It measures the same as the current ratio by excluding inventory because the inventory might take more time to convert into cash. It is also called as Acid-test ratio.
Quick assets are those which immediately converted into cash or within 90 days, like cash, bank balance, marketable and receivables.
Quick Assets =
Generally, 1:1 is considered as a good ratio for financially stable companies.
AFC Company has Rs. 10, 00, 000 in the form of cash, marketable securities & receivables and the total liabilities is Rs. 1200,000 then quick ratio is 0.83 to 1 (1,000,000 /1,200,000 = 0.83).
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- It also emphasises on the liquidity position of a firm
- It is removed the drawbacks of a current ratio
- It can be used as supplementary of the current ratio.
Defensive-Interval Ratio (DIR):
Defensive-Interval ratio explains how many days a firm can operate without using any other current assets or financial resources after paying its current liabilities. This liquidity ratio assesses the liquidity in the light of meeting daily cash requirement.
DIR is popular for its unique features of comparing the current assets to the projected daily cash expenditure of a company.
If ABC Company has 50 days DIR, which indicates ABC Company can operate successfully for the period of 50 days without needing any extra current assets.
Projected Daily Cash Requirement =
Current Assets =
Daily Expenditures =
The higher ratio would be considered good for companies to meet cash requirement for a long period of time.
AFC Company has liquid assets of Rs. 40,000. At the same time, the daily expenditure is Rs. 1, 82,500. DIR will be calculated as:
Projected daily cash requirement= (182500/365) = 500
DIR= 40000/500= 80days
The above examples elaborate that AFC Company can operate for 80 days without resorting the other financial resources.
Absolute Liquidity Ratio
It measures the availability of liquidity in terms of cash and marketable securities only against the current liability. This ratio discussed only short-term liquidity requirements.
Cash Conversion Cycle Ratio
Cash conversion cycle represents the cash is required for the average no. of days in the receivables and inventories. When a company purchase any inventory then cash is tied up until the inventories get sold and it converted into receivables. During the initial phase, the company can obtain its inventory on a credit basis, in that case, the owner cash doesn’t involve but the collection period may vary and affect its whole conversion cycle. The following formula can be helpful in determining the conversion cycle-