Question

What is the liquidity Ratio? Define current Ratio.

Hint:

Remember: Current Ratio = Current Assets / Current Liabilities. It measures short-term solvency. A ratio of 2:1 is generally considered healthy, meaning the company has twice the assets needed to cover its short-term debts.

Answer 1

Step 1: Definition of Liquidity Ratio
Liquidity ratios are financial metrics used to measure a company's ability to pay off its short-term debt obligations using its current or liquid assets. They indicate how easily a company can convert its assets into cash to meet immediate liabilities.

Step 2: Types of Liquidity Ratios
Common liquidity ratios include:

• Current Ratio
• Quick Ratio (Acid Test Ratio)
• Cash Ratio
• Net Working Capital Ratio

Step 3: Definition of Current Ratio
Current Ratio is a liquidity ratio that measures a company's ability to pay its short-term obligations (due within one year) using its current assets. It is the most commonly used liquidity ratio.

Formula:
Current Ratio = Current Assets / Current Liabilities

Components:

• Current Assets: Cash, marketable securities, accounts receivable, inventory, prepaid expenses
• Current Liabilities: Accounts payable, short-term debt, accrued expenses, taxes payable

Step 4: Interpretation of Current Ratio

• Ratio > 1: Company has more current assets than current liabilities – good ability to pay short-term debts
• Ratio = 1: Current assets equal current liabilities – just able to meet obligations
• Ratio < 1: Current assets less than current liabilities – potential liquidity problem
• Ideal ratio: Generally considered 1.5 to 2 (varies by industry)
• Too high ratio (>3): May indicate inefficient use of assets (excess inventory or poor cash management)

Step 5: Example
If a company has:
Current Assets = ₹10,00,000
Current Liabilities = ₹5,00,000

Current Ratio = 10,00,000 / 5,00,000 = 2 : 1
This means the company has ₹2 of current assets for every ₹1 of current liabilities, indicating a comfortable liquidity position.

Step 6: Limitations of Current Ratio

• Includes inventory which may not always be easily convertible to cash
• Does not consider timing of cash flows
• Can be manipulated (for example by delaying payments)
• Industry standards should be considered for proper interpretation