9.13 Liquidity ratios

Ratio analysis

These ratios indicate how liquid the company is.

(a) Current Ratio:

This is defined as

Current Assets
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Current Liabilities

Remember that here current liabilities will include short-term loans as well.

(b) Quick Ratio:

This is defined as

Current Assets - Inventory
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Current Liabilities

What is the importance of the liquidity ratios?

Liquidity ratios explain you how liquid the company is in fulfilling day-to-day expenses. Ideally, a current ratio of 2:1 and a quick ratio of 1:1 are good for any company. But note that these ratios vary across industries. It is therefore better to compare these ratios across the industry as well as the yearly trend for a few years. A very high ratio is bad. It means the company is unable to utilize its resources. But, during the credit squeeze in 1991 by the RBI, companies with high liquidity were better off than their competitors. Low liquidity ratio is also bad, showing a liquidity crunch. If the current ratio falls below one, the situation is alarming. It means that the company is unable to meet its current liabilities from its current assets. In such situations, some companies divert their long-term funds for meeting short-term uses. This is not good for the long-term health of the company.