It is but natural to proceed another step forward after completing on step, which is why now we will understand the classification of ratios analysis and discuss Liquidity ratio. Accounting ratio indicates the financial position of a firm, and the classification of the ratio also depends on the [party using it. The three broad classifications are based on Balance Sheet, basis of Profit and Loss Account, and basis of Mixed Statement. These classifications are then grouped into three types of ratio—Liquidity, Profitability, Turnover, and Solvency. To help you better, here is a chart:
It is important for us to know a little about all these ratio types. The Liquidity ratio is about the quick conversion of assets into money to meet the short-term goals. Though instrumental, it does not bring to light the effective management of cash resource and is also known as Short-term Solvency Ratio. Then, there types of Liquidity Ratios, the ones we will discuss in brief are the common ones.
The first one is the Current Ratio. This establishes the relationship between current assets and liabilities, the two pivotal components of this ratio. The assets that can be converted into cash within the span of a year are current assets, the liabilities that can be paid off within a year. And like many other things, it has two sides to itself—advantages and disadvantages. Some of these advantages are that it measures the liquidity of the firm, represents the working capital and short-term solvency of a firm. While the disadvantages of Current Ratio are that the accuracy can not be proofed because of the different businesses, variant factors, and over-valuation of stocks.
The simple calculation for Current Ratio is:
Current Ratio = Current Assets / Current Liabilities
The next is line to be known is the Quick Ratio. Due to its stringent and meticulous test of the capability of a firm in paying its short-term obligations on the due date, it is also known as Acid Test Ratio. This can help taking care of the quick assets and current liabilities. The ideal Quick Ratio is 1: 1. Some of its advantages are like it tells the liquidity position of a firm, removes the errors of current ratio, and is the supplementary to the current ratio.
Quick Ratio = Liquid Asset (Current Assets – Stock & Prepaid Expenses) / Current Liabilities
The third type of Current Ratio that we would here learn about is the Absolute Liquid Ratio. This ratio establishes the relationship between the absolute liquid assets and current liabilities. Also, it considers the cash in hand and at bank, and the marketable securities or temporary investments. The most favourable and optimum value for this ratio should be 1: 2. It indicates the adequacy of 50% worth absolute liquid assets to pay the 100% worth current liabilities in time.
Absolute Liquid Ratio = Absolute Liquid Ratio / Current Liabilities
This was just a little detail on all the three Current Ratios and at large, a bit on the Liquidity Ratio. To find more, you need to read the proper blog on our website. After all, it is good learn through the short route, but it is always nicer to learn through the proper detailed text.