A small study on liquidity ratios with examples

1. LIQUIDITY RATIOS

2. SYNOPSIS
• Ratio analysis
• Liquidity ratios
• Current ratio
• Quick ratio
• Limitations of Ratio analysis
• conclusion

3. RATIO ANALYSIS
 It is a method or process by which the relationship of items or groups
of items in the financial statements are computed, and presented.
 In other words Ratio analysis is the process of determining and
interpreting numerical relationship based on financial statements.
 Important tool of financial analysis.
 Ratio can be expressed as
I. Percentage(ex: 10% of sales ,20% of revenues)
II. proportion(ex: 1:4,2:3)
III. pure number /times(ex: sale is 4 times of profit)

4. LIQUIDITY RATIOS
 The liquidity ratios are used to test the short term solvency or liquidity
position of the business.
 It enables to know whether short term liabilities can be paid out of
short term assets.
 It indicates whether a firm has adequate working capital to carry out
routine business activity.
 Important ratios in liquidity
I. current ratio
II. quick ratio/acid test

5. CURRENT RATIO
 It is the relationship between the current assets and current liabilities of
a concern.
Current Ratio = Current Assets/Current Liabilities
 Current Assets : Raw Material, Stores, Spares, Work-in Progress.
Finished Goods, Debtors, Bills Receivables, Cash.
 Current Liabilities : Sundry Creditors, Installments of Term Loan,
DPG etc. payable within one year and other liabilities payable within
one year.
 Ideal ratio is 2:1
 High ratio indicates under trading and over capitalization.
 Low ratio indicates over trading and under capitalization.
 The ideal Current Ratio preferred by Banks is 1.33 : 1.

6. Contd..
 Example: If the Current Assets and Current Liabilities of a concern are
Rs.4,00,000 and Rs.2,00,000 respectively, then
Current Ratio will be : Rs.4,00,000/Rs.2,00,000 = 2 : 1.
Company A
Current Assets: 500,000Rs
Stock: 200,000Rs Cash: 100,000Rs Debtors: 200,000Rs
Current Liabilities: 350,000Rs
Current ratio = 500,000/350,000
Current Ratio- 1.43:1
Meaning: For every 1 rupee of current liabilities, the firm has 1.43 of
current assets.

7. ACID TEST/QUICK RATIO
 It is the ratio between Quick Current Assets and Current Liabilities.
The should be at least equal to 1.
Acid Test or Quick Ratio = Quick Current Assets/Current Liabilities.
 Quick Current Assets : Cash/Bank Balances ,Receivables up to 6
months ,Quickly realizable securities such as Govt, Securities or
quickly marketable/quoted shares and Bank Fixed Deposits.
 Conventionally a quick ratio of 1:1 is considered satisfactory.
 If the ratio is too high, the company may be holding excessive liquid
assets.
 If the ratio is too low, the company may have a liquidity problem / cash
flow problem.

8. Contd..
Company A
Current Assets: 500,000
Stock: 200,000 Cash: 100,000 Debtors: 200,000
Current Liabilities: 350,000
(500,000- 200,000)= 300,000
_______________
350,000
Acid Test Ratio- 1:1.12
Meaning: For every Rs.1.12 of current liabilities, the firm has Rs.1 of
(current assets- stocks) = Possible that the firm is experiencing a
LIQUIDITY CRISIS!!

9. LIMITATIONS OF RATIO ANALYSIS
 Changes in price level will affect the comparability of the ratios
between two financial periods.
 Changes in external environment will affect the comparison.
 Different accounting definitions, methods, techniques and policies
used by various businesses may affect the comparability.
 Qualitative factors are not considered.
 Organizational objectives differ between businesses (misleading) Ex.
Supermarkets and Jewelry shops.
 It is difficult to set up a proper standard for good performance.
 Short term fluctuations may not be reflected.

10. CONCLUSION

11. THANK YOU!!!