Current Ratio & Quick Ratio: Use of Liquidity Ratios

Liquidity ratios are helpful to measure the short-term solvency of the business, i.e., the firm’s ability to pay off its short-term obligations from its cash and easy cash converting assets. These are analysed by looking at the balance sheet’s current assets and current liabilities. The two ratios included in this category are the current ratio, the Quick ratio, and the Operating Cash Flow Ratio

A. Current Ratio:

The current ratio is the weightage of current assets compared to current liabilities. It is expressed as follows:

Current Ratio = Current Assets divided by Current Liabilities

Current assets mean those assets that can be converted into cash within 12 months from the beginning of the financial year or converted into cash within the business’s operating cycle. Current assets include current investments, inventories, trade receivables(also known as debtors and bills receivables), cash and cash equivalents, short-term loans and advances, and other current assets such as prepaid expenses, advance tax, accrued income, etc. Current liability means a liability that is required to be paid off within 12 months from the beginning of the financial year or within the business’s operating cycle. Current liabilities include short-term borrowings, trade payables (creditors and bills payables), salaries payable, short-term provisions, etc. Example: Extract from Financial Statements of ABC Incorporation:

PARTICULARS	AMOUNT
Inventories	60,000
Trade Receivables	40,000
Advance Tax	3,000
Cash and Cash equivalents	30,000
Trade Payables	80,000
Short Term Borrowings (Bank overdraft)	24,000

Current Ratio = (Current Assets/Current Liabilities) Current Assets = Inventories + Trade Receivables + Advance Tax + Cash & Cash Equivalents

  = 60,000 + 40,000 + 3,000 + 30,000

  = 1,33,000

Current Liabilities = Trade Payables + Short Term Borrowings

= 80,000 + 24,000

Current Ratio = $ \frac{134000}{104000} $   = 1.28 : 1

Significance of Current Ratio

The current ratio helps to understand how many current assets a business has to cover its current liabilities. The excess of current assets over current liabilities provides a safety margin available in case of liquidation of a business. The ratio should be ideally 2:1. It should neither be too high nor too low. Both situations have their inherent disadvantages. A high current ratio indicates the underutilisation of funds in the business. In contrast, a low ratio puts the business at risk of facing a situation where it will not be able to pay its short-term debt on time. If this problem persists, it may affect a firm’s creditworthiness adversely.

B. Quick Ratio:

Quick Ratio is a ratio that helps an investor or a business owner to know how many quick cash converting assets a business has to cover its entire current liabilities. Current liabilities remain the same in this ratio, whereas quick assets that can be readily converted into cash are used instead of current assets. Quick assets are those assets that can be realised into cash within three months. A few examples of quick assets are Marketable securities like Zero-coupon bonds, 90 days fixed deposits, cash, bank balance, etc. Formula: Quick Ratio = (Quick Assets/Current Liabilities) Example: Extract from Financial Statements of ABC Incorporation:

PARTICULARS	AMOUNT
Inventories	60,000
Trade Receivables (To be realised in 40 days)	40,000
Advance Tax	3,000
Cash and Cash equivalents	30,000
Trade Payables	80,000
Short Term Borrowings (Bank overdraft)	24,000
90 Days Marketable Securities	4,000

Quick Ratio = (Quick Assets/Current Liabilities) Quick Assets = Trade Receivables + cash and cash equivalents + Marketable securities

= 40,000 + 30,000 + 4,000

= 74,000

Current Liabilities = Trade Payables + Short Term Borrowings = 80,000 + 24,000 Current Ratio = $ \frac{74000}{104000} $ = 0.71 : 1

Significance of Quick Ratio:

The significance of the quick ratio is that it helps to know about the situation and whether the business would be able to repay all of its current liabilities flawlessly within a very short period of time or not. Generally, a 1:1 quick ratio considers as healthy for a business.

C. Operating Cash Flows

Operating cash flows are the actual amount of cash that the business earns during a period of time from its operating activities. The good thing about this OCF matrix is that it eliminates the drawbacks of reported earnings in the business’s financial statements. Businesses in their financial statements use the matching concept, which states that all the expenses incurred by the entity against the revenue generated should be reported in the financial statement. Due to this reason, both cash and non-cash expenses are reported against the revenue. The addition of non-cash expenses against revenue shows less profitability to the end-users. Sometimes it shows the net loss instead of net profit. Hence, to fully understand the accurate picture of the cash-generating ability of the entity, investors or business owners use the operating cash flows matrix. Example: In the financial statement of ABC Incorporation, the revenue of \$ 100,000 and expenses of \$ 110,000 resulted in a net loss of \$ 10,000 reported at the end of the year. This net loss of \$ 10,000 shows the underperformance of the business. Still, when we checked the expenses in detail, we found out that out of a total of \$110,000, non-cash expenses were \$ 30,000, which included depreciation of \$ 18,000 and provisions of \$ 12,000. So, to know real cash profits, we added back non-cash expenses of \$ 30,000 in a net loss of \$ 10,000, which ultimately resulted in \$ 20,000 of cash profits. This gives the true picture of the performance of the business during the year.

Why Is Liquidity Is Important For A Business:

In finance, they say, “Cash is king”. Any business that has more cash and cash equivalents to pay off its bills or liabilities at all times brings more health to it. Smooth and timely cash inflows and outflows are required for any business to run its day-to-day operations. Liquidity also brings a good reputation to the business as they always find themselves in the position to repay all their short-term obligations.