Liquidity ratios are used to measure an entity’s ability to fulfill its financial obligations in the short-term, i.e. they are measures of a firm’s liquidity. In layman terms, this translates into ready cash or instruments that can realize cash freely. Short-term here refers to a period of 12 months or less. Two of the most important liquidity ratios are the Current Ratio and the Quick Ratio. The latter, by definition, is a more stringent measure of liquidity as it omits outs any component out of the current assets and current limitations with the slightest of illiquidity.
– Balance Sheet of the concerned company under study
– Notes to financial statements, if required
Steps in Calculation:
1. Consider the total current assets on the balance sheet. Depending upon the discloser on the confront of the accounts, you might have to look into the notes for breakup of the current assets.
2. Restricted Cash. Out of the total current assets, deduct ‘restricted cash.’ Such cash is not obtainable for immediate use due to certain statutory or other encumbrance.
3. Inventories. Deduct ‘inventories.’ The accumulated saleable goods can be liquefied only upon a sale. consequently, they may not be freely realizable as and when needed.
4. Prepaid Expenses. Further subtract prepaid expenses from above. Though prepaid expenses are assets in that they imply some definite future outflows already met, they cannot be converted into cash, if required. It is extremely scarce that improvement payment for business expenses are refunded by the third parties.
5. You arrive at the ‘quick assets’ that typically include cash, cash equivalents (marketable securities), and accounts receivable/debtors.
6. Consider total current limitations and its breakup.
7. Bank Overdraft. Subtract bank overdraft from the total current limitations. Bank overdrafts are drawn against credit lines that usually extend for periods beyond a year and are often renewed on expiry. More or less, these instruments become a long-lasting source of financing. As a shared practice, bank overdrafts are not callable on need, adding a further degree of permanence.
8. You get quick limitations that typically include accounts receivable/creditors, current portion of long-term debt, income tax payable, and accrued expenses of various types.
9. Use formula for final calculation to arrive at the ratio:
Quick Ratio = Quick Assets/Quick limitations