Liquidity represents one's ability to pay its current obligations or short-term debts within a period less than one year. Liquidity ratios, therefore, measures a company's liquidity position. The ratios are important from the viewpoint of its creditors as well as management. The liquidity position of the company can be measured mainly by using two liquidity ratios such as follows.
a. Current Ratio
b. Quick Ratio
a. Current Ratio
Current ratio is also known as short-term solvency ratio or working capital ratio. Current ratio is used to assess the short-term financial position of the business. In other words, it is an indicator of the firm's ability to meet its short-term obligations.
Current ratio is calculated by using following formula:
Current ratio = Current assets/Current liabilities
Current assets are cash and those cash equivalent of a business which can be converted into cash within a short period of time not exceeding a year. Cash in hand, cash at bank, bills receivables, sundry debtors, accrued incomes, prepaid expenses, inventory, short term loans provided , advance given etc are the examples of current assets.
Current liabilities are those obligations of a business, which are to be paid within in a short period of time not exceeding a year. Bills payable ,sundry creditors, short term loan taken, income tax payable, dividend payable, advance incomes, accrued expenses are the examples of current liabilities.
b. Quick Ratio
Quick ratio is another measure of a company's liquidity. Quick ratio is also known as liquid ratio or acid test ratio. However, although it is used to test the short-term solvency or liquidity position of the firm, it is a more stringent measure of liquidity than the current ratio. This ratio is calculated by dividing liquid assets by current liabilities. Liquid assets are cash and other assets which are either equivalent to cash or convertible into cash within a very short period of time.
The following formula is used to calculate quick ratio:
Quick Ratio = Liquid assets/Current Liabilities
Liquid assets = Total current assets - stock- prepaid expenses