Posted in Finance, Accounting and Economics Terms, Total Reads: 655
Definition: Liquid Ratio
Liquid Ratio, also known as acid-test ratio or quick ratio is a measure of a company’s short term liquidity. It evaluates the company’s ability to use its most liquid assets to pay its short term liabilities and is calculated by the following formula:
The quick ratio is a more conservative and rigorous test of liquidity than Current Ratio and considers only those assets that are readily convertible to cash. The term ‘Quick’ signifies that the assets such as cash and marketable securities are quick sources of cash. Current assets like inventory and prepaid expenses are excluded as they more difficult to convert into cash. Inventories may take longer time to get converted into cash and prepaid expenses cannot be usually converted back to cash as they represent costs of the current period that have been paid in advance.
From the Balance Sheet of Company XYZ we see that it holds Rs. 50,000 in cash (in hand and bank), Rs. 20,000 in accounts receivable, and Rs. 10,000 in marketable securities and Rs. 60,000 in Current Liabilities.
Quick ratio = (50000+20000+10000)/60000 = 1.333
The quick ratio is an indicator of short-term solvency of a company as it shows its ability to pay short term debts immediately and measures its absolute liquidity. It must be analyzed over a period of time taking the industry in which the company is operating in perspective. Companies should maintain a liquid ratio that protects it against liquidity risk considering the level of predictability and volatility of the industry of the company.
A balance has to be made between higher and lower levels. Low quick ratio might mean company is taking too much risk while a high value might mean company is investing too much in working capital that can be used profitably elsewhere. Seasonal variations in particular type of industry also need to be considered while analyzing the ratio over several periods. Generally a quick ratio of 1:1 is regarded as satisfactory but companies with fast turnover of cash, a lower value is accepted.