Write short notes on Current Ratio, and Liquid Ratio.
It is also known as working capital ratio. It is the ratio of current assets of current liabilities. It shows a firm’s ability to cover its current liabilities.
It is expressed as follows :
Current Ratio = Current assets / Current Liabilities
Current assets are assets which are readily convertible into cash within one accounting year.
- Closing Stock of Raw Materials/ work in Progress/Finished Goods,
- Bills Receivables,
- Short-term loans and advances given,
- Prepaid expenses,
- Accrued Incomes,
- Cash in hand and at banks etc.
Current Liabilities are liabilities that must be discharged within one accounting year.
- Bills Payable,
- Income received in advance,
- Short term Loans and Advance.
Objective and Significance of Current Ratio:
The objective of the computing the ratio is to measure the ability of the firm to meet its short term obligations and to reflect the short-term financial strength of a firm. Higher the current ratio the greater the short-term solvency. 2 : 1 is considered ideal current ratio. However, a very high ratio will indicate idleness of working capital only.
It is also known as Acid Test Ratio, Quick Ratio : It is calculated by dividing the Quick Assets by the Quick liabilities.
Liquid Ratio = Quick Assets / Quick Liabilities = Current Assets – Stock – Prepaid expenses / Current Liabilities – Bank overdrafts
Quick Assets refers to those current assets which can be converted into cash immediately or at a short notice without a loss of value. Therefore, quick assets are current assets less stock and prepaid expenses, i.e., cash bank debtors and readily realizable marketable securities.
Quick or Liquid Liabilities include all items of current liabilities except bank overdraft because bank loans are taken and not to be repaid immediately. However, if bank overdraft is payable on demand, such should be included within quick liabilities.
Objective or Significance of quick ratio : The objective of computing this ratio is to measure the ability of the firm to meet its short-term obligation as and when due without relying upon the realization of stock.
The quick ratio of 1: 1 is considered an ideal ratio for a concern because it is wise to keep the liquid assets at least equal to the liquid liabilities at all times. This ratio is also an indicator of the short-term debt paying capacity of a business enterprise. The greater the ratio the better is the concern’s ability to pay-off financial commitments.