Liquid ratio, also known as quick ratio, is used to determine the liquid assets of a company which may be used to pay off short term debts or obligations of the company. Liquid ratio is one of the ratios used in the ratio analysis. Before moving further, let us understand, what is liquid asset?
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Liquid Asset
The liquid asset is an asset, which can be converted into cash in a short period and it includes the assets like cash, money market instruments, marketable securities, short term bonds, account receivables, etc. These liquid assets are marked as current assets in the balance sheet of the company, for the purpose of accounting.
Now we come to our main topic of this post, i.e. liquid ratio or quick ratio.
What is Liquid Ratio or Quick Ratio?
Liquid ratio is an indicator of the liquidity of a company. A good liquid ratio establishes the fact the company have enough liquid assets to pay off its short term debts and obligations. The liquid ratio is used to derive a relation between the current assets and current liabilities of a firm. In other words, a liquid ratio tells us how much current assets are laying with the company in comparison of the current liabilities of the firm. It is also called the quick ratio or acid test ratio.
How to Calculate the Liquid Ratio or Quick Ratio?
Where, Liquid Assets = Cash + Accounts Receivable + Short term Investments (Marketable Securities)
or
Liquid Assets = Current Assets – Inventory – Prepaid Expenses
Current Liabilities = Bank Overdraft + Trade Payables + Provision of Taxation + Proposed Dividends + Unclaimed Dividends + Outstanding Expenses + Loans Payable within a Year
Significance of the Liquid Ratio
By knowing the liquidity ratio one can determine the ability of the firm to pay off its short term debts and liabilities. In other words, liquid ratio compares the current assets with the current liabilities. If the current assets are more than the current liabilities, it means that the firm is able to pay its short term debts by liquidating its current assets.
The ideal liquid ratio is 1:1, which means that the current assets of the company are equal to the current liabilities of the company. If the liquid ratio is very high, it means that the funds of the company are laying idle. The liquid ratio is also useful for the creditors, banks and financial institutions to determine the creditworthiness of the firm. If the current ratio of a company is high, then the creditors feel confident in advancing loans to the company.
Different values of the liquid ratio may be interpreted as follows:
If Liquid Ratio>1, it means that the current assets of the company are more than the current liabilities. It means that the firm is capable of repaying its short term debts and it will still have some assets after paying off its all short term debts. It’s a desirable situation for the investors, creditors and the management of the company.
If Liquid Ratio = 1, it means that the current assets of the company are equal to the current liabilities and the company have just sufficient assets to pay off its short term debts.
If Liquid Ratio<1, it indicates that the current assets are less than the current liabilities of the company and it is not capable of paying its short term debts and obligations. This situation should be avoided as the company may face difficulty in getting loans in this case.
Example 1
Calculate the liquid ratio of the firm, ABC Pvt. Ltd. from the data given in the following balance sheet for the year ending March 2022.
| Particulars | Amount (in ₹) |
| Equity and Liabilities Shareholder’s Fund: | |
| Share Capital | 8,00,000 |
| Reserves and Surplus | 1,50,000 |
| Profit as per income statement | 30,000 |
| Non-Current Liabilities: | |
| 15% Debentures | 115000 |
| Long- term Provisions | 175000 |
| Current Liabilities: | |
| Sundry Creditors | 55000 |
| Bank Overdraft | 45000 |
| Outstanding Expenses | 2500 |
| Provision for Tax | 9500 |
| Proposed Dividend | 18000 |
| 1400000 | |
| Assets Non-Current Assets | |
| Land | 300000 |
| Building | 125000 |
| Plant and Machinery | 390000 |
| Patents | 100000 |
| Goodwill | 50000 |
| Investments | 120000 |
| Current Assets | |
| Inventory | 35000 |
| Debtors 1,00,000 Less: Provision (10,000) | 90000 |
| Bills sent for Collection | 65000 |
| Marketable Securities | 20000 |
| Prepaid Expenses | 50000 |
| Cash and Bank | 55000 |
| 1400000 |
Solution:
Liquid Assets = Debtors + Bills sent for collection + Marketable Securities + Cash and Bank
= 90000 + 65000 + 20000 + 55000 = ₹230000
Current Liabilities = Bank Overdraft + Sundry Creditors + Outstanding Expenses + Provision for Tax + Proposed Dividend
= 45000 + 55000 + 2500 + 9500 + 18000 = ₹130000
Example 2
Calculate the current ratio of the firm using the following data.
Current Assets ₹1,35,000; Inventory ₹23,000; Working Capital ₹55,000.
Solution:
Quick Assets= Current Assets – Inventory
= ₹135000- ₹23000 = ₹112000
Working Capital = Current Assets – Current Liabilities
Current Liabilities = Current Assets – Working Capital
= ₹135000 – ₹55000 = ₹80000
Conclusion
The liquid ratio, also known as quick ratio or acid test ratio, is an important component of the ratio analysis, which determines the capability of the firm to pay off its short term debts or obligations. It compares the current assets of with the current liabilities of the firm. If the current assets are more than the current liabilities, it means that the firm is able to pay its short term debts by liquidating its current assets. The ideal liquid ratio is 1:1, which means that the current assets of the company are equal to the current liabilities of the company. If the liquid ratio is very high, it means that the funds of the company are laying idle. This ratio is also useful for the creditors, banks and financial institutions to determine the trustworthiness of the company.
Read more: Inventory Turnover Ratio: Examples and Importance
