- Business and Employment
SHORT TERM LIQUIDITY RATIOS
Short term liquidity ratios measure the ability of a company to pay off short term debts due in the very near future and have enough money to finance its day to day business operations i.e., the ability to survive in the short-run. The short term creditor of the company like supplies of goods the credit and commercial bank providing short term loans are primarily interested in knowing the company ability to meets its current obligation as and when they became due. The short term obligation can only be met when there are sufficient liquid assets if the firm fail to meet such obligation its good will be effected in the market and it will result in the loss of creditor confident. But a vary high liquidity position is not good because it means the firm has tied up excessive fund in the current assets so it is vary important to have a proper balance in regard to the liquidity of the firm.
i) Current Ratio:
Current ratio is calculated by dividing current assets by current liabilities. This ratio shows that how much current assets a company has against current liabilities. And how efficiently company uses its current assets to generate more profit and higher ratio shows better performance. The accepted benchmark for current ratio is 2:1. Current ratio above or below this level is not acceptable for any company. If the current ratio is above this limit, that shows over capitalization which shows too much investment in current assets thus reducing the profitability of the company and current ratio below the benchmark limit is the sign of over trading which shows that company is trying to expand its operations without strong cash base. Over trading is the define sign of liquidity problems and current ratio below the benchmark limit shows that company might not be able to pay off its liabilities on due date thus liquidation may follow.
ii) Quick Ratio:
Quick ratio is also known as Acid test ratio. This ratio is calculated by dividing current assets excluding stocks by current liabilities. The reason for exclusion of stock is the fact that stock is a least liquid asset. The acceptable benchmark for quick ratio is 1:1. This ratio measures the ability of a company to use its near cash or quick assets to immediately extinguish its current liabilities. Quick assets include those current assets that apparently can be quickly converted to cash at close to their book values. Such items are cash, marketable securities, and some accounts receivable. This ratio indicates a firm's capacity to maintain operations as usual with current cash or near cash reserves in bad periods. As such, this ratio implies a liquidation approach and does not recognize the revolving nature of current assets and liabilities. The ratio compares a company's cash and short-term investments to the financial liabilities the company is expected to incur within a year's time.