What is liquidity ratio?

Liquidity ratio is the quotient that is used to measure the easiness with which the organization can meet its short-term debt obligation as and when they fall due. To achieve this perspective, the quotient used compares assets and liabilities of an organization.

There are several ways in which these ratios can be expressed, but the most commonly used and useful ones are namely;

  1. Current Ratio
  2. Acid Test Ratio or Quick Ratio

1.Current Ratio

This ratio portrays the extent to which assets that are convertible into hard cash cover the liabilities which are convertible within a year. The point here is, is current assets which are properties of the business able to cover the current debts?

Contribution made by current assets to current liabilities

Formula

This ratio shows the number of times current assets cover short-term debt of the business and the more or high the number of coverage is, the better. The reverse is dangerous to the organization. In finance and accountancy, the accepted ratio is that of 2:1 which is interpreted as; for every two units of a particular currency emanating from current assets, one unit of a currency is used to pay short term debt obligation. Therefore, the higher the ratio, the higher the liquidity level and the lower the ratio the poor the liquidity level of the business.

Applicability of Current Ratio in Decision Making by Management

Denominator factor; the denominator factor is the current liabilities which entail trade creditors also known as accounts payable, bank overdraft, accrued expenses, income in advance and other similar debts. The relevance of this denominator in decision-making is that, short-term financing involves identifying the suitable source of funding, given the cash conversion cycle (CCC). For example, inventory is in reality financed by credit granted by the creditors of either goods or services. If trade creditors are costly, an alternative can be considered such as short-term bank loan or to “convert debtors to cash. Another possible solution is to use services from companies sell outstanding invoices to raise working capital for their clients.

Numerator factor;

The numerator factor is composed of current asset which entails cash in hand, cash at the bank, trade debtors, inventory, prepaid expenses and accrued income just to mention but as few of them. These components of current assets represent diverse managerial decision logistics.

One; The measure of cash flow is provided by the cash conversion cycle (CCC)–the net number of days from the outlay of cash for trade debtors to receiving payment from the customer. So, if the CCC is a short one, the debtors are converted in to cash and this makes easy and convenient to the management to meet the firms debt obligations as and when they fall due

Two; decision on cash in hand and at bank are critical for as much as the availability of the same makes the business meet its obligations with ease, there is also the risk of lost opportunity cost for such current assets are referred to as idle cash and does not generate any interest. In fact, they are referred to as non-interest assets.

Three; inventory management is also important for failure to make the right choice of the inventory, it may result to difficulties in realizing cash needed to solve liquidity issues. This aspect can be debated in threefold ways;

  1. Inventory of finished goods-if wrong choice of merchandized goods is undertaken, then there may arise cases of slow moving inventory which result to difficulties in liquidity status of the business
  2. Inventory of raw materials-Choice of high quality raw materials improves productivity efficiency and makes it easy to convert complete units in to hard cash
  3. Inventory of work in progress-this category of inventory need to be appropriately valued otherwise profitability will be over-valued.

Example

Required

Determine

Current ratio and interpret the results

Solution

Interpretation

For every three units of $ of current assets of a business, there is a corresponding one unit of $ of current liability. This means current assets cover current liability three times and the business is safe from any liquidity problems.

2.Quick Ratio

It is also referred to as Acid test Ratio and it portrays the relationship between total current assets net of inventory over total current liabilities.

Contribution made by current assets net of Inventory to current liabilities

Formula

This ratio displays the number of times current assets cover short-term debt of the business and the more or high the number of coverage is, the better. The reverse is dangerous to the organization. In finance and accountancy, the accepted ratio is that of 1:1, which is interpreted as; for every one unit of a specific currency, originating from current assets, one unit of a currency is used to pay short-term obligation responsibility. Therefore, the higher the ratio, the higher the liquidity level and the lower the ratio the poor the liquidity level of the business.

This ratio is more appropriate especially in a case where the inventory is slow moving in nature.

Applicability of quick ratio in decision making by management

Denominator factor; the denominator factor is the total current liabilities which entail accounts payable, bank overdraft, accrued expenses, income in advance and other related arrears. The management need to consider opportunity cost of each source of short-term financing for some may be more costly as far as forgone benefits s concerned. For instance, if the management choose bank overdraft as the key source of financing current assets, the business may forgo cheaper source of financing such as accrued expenses or accounts payable which does not attract any interest charge. So apart from just considering the resultant change in the current asset investment due to a unit change in current liabilities, it is paramount for the management to consider opportunity cost for each individual component of current liability.

Look at this…..

  1. Accounts Payable-if choose accounts payable as a source of financing current assets, you forgo benefits of the other sources of financing such as tax shield benefit from interest emanating from bank overdraft which is tax allowable expense. you will also forgo cheap source of financing current asset using accrued expenses such as delayed salaries which when paid at a later date does not attract any interest. Again the same accrual expenses are treated as business expense hence reduce the amount of taxable income.
  2. Bank Overdraft-if the management choose bank overdraft as the key source of financing current assets, the business may forgo cheaper source of financing such as accrued expenses or accounts payable which does not attract any interest charge.

Numerator factor;

Although the numerator is composed of all other current assets except inventory, it is necessary for the management to consider the idle cash which is key in fostering liquidity but not income generating. The management should consider the trade-off balancing between the available income generating opportunities and liquidity. This will be achieved by the management by weighing the demands of the creditors who want to be paid their dues and the short lived investments that can easily be financed by available cash.

Example

Required

Determine

Quick/(Acid test) ratio and interpret the results

Solution

Interpretation

For every 1.69 units of  $ of current assets net of inventory, there is a corresponding one unit of  $ of current liability. This means current assets cover current liability almost twice and the business is safe from any liquidity problems. A ratio of 1:1 is assumed to be more appropriate.