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Understanding the Liquidity position of a Firm



The terms ‘liquidity’ and ‘short-term solvency’ are interlinked. It means the ability of the business to pay its short-term Obligations. Failure to pay-off short-term obligation affects its credibility as well as its credit rating.


Continuous default on the part of the business leads to business bankruptcy. Ultimately such business bankruptcy may lead to its sickness and dissolution. Short-term lenders and creditors of a business are very much concerned to know its state of liquidity because of their financial stake. Usually, two ratios are used to put emphasis on the business ‘liquidity’. These are current ratio and quick ratio. Other ratios include cash ratio, interval measure ratio, and net-working capital ratio.

Firm's Liquidity



Current Ratio

The Current Ratio reflects the financial strength. A simple measure that estimates whether the business can pay debts due within one year from assets that it expects to turn into cash within that year. A ratio of less than one is often a cause for concern, particularly if it persists for any length of time.


  • Current Ratio = Current Assets / Current Liabilities


         Where,

  • Current Assets =

(Inventories + Sundry Debtors + Receivables/Accruals + Cash and Bank Balances + Loans and Advances + Disposable Investments)

  • Current Liabilities =

(Short-term Loans + Bank Overdraft + Cash Credit + Creditors for goods and services + Outstanding Expenses + Provision for Taxation + Proposed Dividend + Unclaimed Dividend)

This ratio answers the question: "Does your business have enough current assets to meet the payment schedule of its current debts with a margin of safety for possible losses in current assets?"

A generally acceptable current ratio is 2 to 1.



Quick Ratio

The Quick Ratio is also known as "acid-test" ratio and is one of the best measures that puts light on the liquidity factor

  • Quick Ratio or Acid Test Ratio = Quick Assets/ Current Liabilities


         Where,

  • Quick Assets = Current Assets −Inventories


  • Current Liabilities =

(Short-term Loans + Bank Overdraft + Cash Credit + Creditors for goods and services + Outstanding Expenses + Provision for Taxation + Proposed Dividend + Unclaimed Dividend)


The Quick Ratio is a much more traditional measure than the Current Ratio. It gives answer to the question “Could my business meet its current obligations with the readily convertible `quick' funds on hand if all sales revenues should disappear?". The quick ratio adjusts the current ratio to eliminate all assets that are not already in cash (or "near-cash") form. Once again, a ratio of less than one would start to send out danger signals.


  • Quick Assets consist of only cash and near cash assets. Inventories are deducted from current assets on the belief that these are not ‘near cash assets’.


An acid-test of 1:1 is considered acceptable unless the majority of "quick assets" are in accounts receivable, and the pattern of accounts receivable collection lags behind the schedule for paying current liabilities.


Net Working Capital Ratio: Net-working capital is more a measure of cash flow than a ratio. The result of this calculation must be a positive number. It is calculated as shown below:

  • Net Working Capital Ratio = Current Assets - Current Liabilities (excluding short-term bankborrowing)


Bankers look at Net Working Capital over time to determine a company's ability to weather financial crises. Loans are often tied to minimum working capital requirements.


Cash Ratio/ Absolute Liquidity Ratio: The cash ratio measures the absolute liquidity of the business.This ratio is calculated as:



Absolute Liquidity Ratio eliminates any unknowns surrounding receivables. The Absolute Liquidity Ratio only examine the short-term liquidity with respect to cash and marketable securities.

Defense Interval Ratio




The Basic Defense Interval would help determine the number of days the company can cover its cash expenses without the aid of additional financing if the company’s revenues by some reason were to suddenly cease.

Also read Ratio analysis
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