Liquidity ratios measure the
firm ability to meet its short term debts as they become due. In other words,
they tell how quickly a firm can convert its current assets into cash in order
to pay off its short term liabilities. The higher the ratio, the better the
position of a firm to pay off its short term obligations. The liquidity ratio
affects the credibility of a firm as well as the credit rating of the firm. Usually,
the liquidity ratio is used by the creditors (lenders) when deciding whether to
extend credit to a business.

##
**What are Types of Liquidity Ratios?**

The liquidity of a business
can measured through the following ratios. These ratios assess the overall
health of a business. These ratios are generally grouped together by financial
analyst when measuring the liquidity of a company.

1. Current ratio

2. Quick ratio

3. Working capital

###
**Current Ratio**

One of the first steps in liquidity
analysis is to determine the firm’s current ratio. The current ratio indicates
how many times over the company can pay its current debt obligations. In other
words, the current ratio shows company’s ability to pay off its current debts
over the next 12 months. This means that
with the larger amount of current assets the company will more easily be able
to pay off its current liabilities. The calculation of current ratio is to
divide current assets by current liabilities. For example the current assets
are Rs. 600 and the current liabilities are Rs. 300. The current ratio would
be:

Current ratio = current assets / current
liabilities

Current ratio = 600 / 300

Current ratio = 2

This means that the company can meet its
current obligations 2 times. In order to be solvent, the company must have a
current ratio of at least 1.0 X. in this case the company can meet its current
obligations and have a left over. So, the company is solvent.

A higher current ratio is always more
favorable than lower current ratio because it indicates the firm can more
easily pay off its current liabilities.

###
**Quick Ratio (Acid Test Ratio)**

The quick ratio is the hard test of
liquidity than the current ratio. It determines how the firm can pay off its
short term liabilities without selling its inventory. It means the quick ratio
does not include firm’s inventory as a current asset. The firm uses the quick
ratio when they need to pay off short term liabilities within 90 days. The quick ratio is calculated by dividing
quick assets (cash + account receivable + marketable securities) by current
liabilities. For example, the quick assets are Rs. 250 and the current
liabilities are Rs. 300. The quick ratio would be:

Quick ratio = Quick assets / current
liabilities

Quick ratio = 250 / 300

Quick ratio = 0.833

This means that the company cannot pay
off its current liabilities because the quick ratio is 0.833 which is less than
1. In order to be solvent, the quick ratio must be at least 1 which is not in
this case.

If the difference between quick ratio and
current ratio is large. This means that the firm is currently relying too much
on inventory.

###
**Working
Capital**

Working capital is the difference between
current assets and current liabilities. In simple words, it is available money
to fund a company’s day to day business expenses. Increasing current assets
lead to increase working capital and it is healthy when working capital is
positive. The working capital can be calculated by excluding current
liabilities from current assets. For example, the current assets are Rs. 600
and the current liabilities are Rs. 400. The working capital would be:

Working capital = Current assets -
current liabilities

Working capital = 600 - 400

Working capital = 200

From the above calculation we have
positive working capital which means the company is able to meet its day to day
business operations. Lack of working capital suffers business from growing.

For the analysis of a company,
it is better to have at least two years of data which provides information on
the trend in the ratios.

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