## Liquidity Ratios

Liquidity ratios measure a firm's capacity to meet its short-term obligations as they fall due. They compare current assets — or progressively more liquid subsets — to current liabilities.

### What Counts as Current Assets and Current Liabilities

Current Assets include:

Inventories / Stocks, Debtors & Bills Receivable, Cash & Bank, Prepaid Expenses, Accrued Income, Short-term Loans & Advances (debit balances), Marketable Investments / Short-term Securities

Current Liabilities include:

Sundry Creditors & Bills Payable, Outstanding Expenses, Short-term Loans & Advances (credit balances), Bank Overdraft / Cash Credit, Provision for Taxation, Proposed Dividend, Unclaimed Dividend

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### 1. Current Ratio ★

Formula: = Current Assets / Current Liabilities

Ideal: 2:1
Very high ratio → idle / unproductive current assets
Very low ratio → liquidity risk, inability to pay short-term dues

### 2. Quick Ratio (Acid Test / Liquid Ratio) ★

Formula: = Quick Assets / Current Liabilities

Quick Assets = Current Assets − Inventories − Prepaid Expenses

Ideal: 1:1
Inventories and prepaid expenses are excluded because they cannot be immediately converted to cash without operational delay.

### 3. Absolute Cash Ratio (Absolute Liquidity Ratio)

Formula: = (Cash in Hand + Cash at Bank + Marketable Securities) / Current Liabilities

No fixed ideal ratio.
Ratio > 1 → excess liquid resources earning low returns.

### 4. Basic Defence Interval Measure (BDIM)

Formula: = Quick Assets / Cash Expenses per Day — in Days

Cash Expenses per Day = Annual Cash Operating Expenses / 365
Cash Operating Expenses = COGS + Selling, Admin & Other Expenses excluding Depreciation and other non-cash items
Significance: Number of days the firm can sustain normal cash operations using only its liquid assets, with no fresh inflows.

Worked example

### Example 1

Example 1 – FLOW Ltd.: All Three Liquidity Ratios (from Question 8)

Balance Sheet (₹ in lakhs) — Current Section:

Current Assets	₹	Current Liabilities	₹
Stock	1.50	Creditors	0.60
Debtors	1.00	Bills Payable	0.20
Prepaid Expenses	0.25	Accrued Expenses	0.20
Marketable Securities	0.75	Provision for Tax	0.65
Cash	0.25	Total CL	1.65
Total CA	3.75

Current Ratio = 3.75 / 1.65 = 2.27:1 ✓ (near the 2:1 ideal)

Quick Assets = CA − Stock − Prepaid = 3.75 − 1.50 − 0.25 = ₹2.00 lakhs

Quick Ratio = 2.00 / 1.65 = 1.21:1 ✓ (above the 1:1 ideal)

Absolute Cash Ratio = (Cash + Marketable Securities) / CL = (0.25 + 0.75) / 1.65 = 1.00 / 1.65 = 0.61

Interpretation: The company can meet 61% of its current liabilities immediately from cash and near-cash resources — a reasonable position for a manufacturing firm.

### Example 2

Example 2 – Ananya Ltd.: Calculating Total Current Assets from Ratios (from Question 5)

Given: Stock Turnover = 5 times; Sales (all credit) = ₹7,20,000; GP Ratio = 25%; Current Liabilities = ₹2,40,000; Liquidity (Quick) Ratio = 1.25; Closing Stock = Opening Stock + ₹30,000

Step 1 – COGS

COGS = Sales × (1 − GP%) = 7,20,000 × 75% = ₹5,40,000

Step 2 – Average Stock and Closing Stock

Average Stock = COGS / Turnover = 5,40,000 / 5 = ₹1,08,000

Let Opening Stock = x → Closing Stock = x + 30,000

(2x + 30,000) / 2 = 1,08,000 → x = ₹93,000 (Opening Stock)

Closing Stock = ₹1,23,000

Step 3 – Quick Assets from Liquidity Ratio

Quick Assets = Quick Ratio × CL = 1.25 × 2,40,000 = ₹3,00,000

Step 4 – Total Current Assets

Total CA = Quick Assets + Closing Stock = 3,00,000 + 1,23,000 = ₹4,23,000

Note: Closing stock is used (not average stock) because the balance sheet reflects closing figures.

⚠️ Common exam mistakes

Including Prepaid Expenses in Quick Assets — they cannot be converted to cash and must be excluded alongside inventories.
Treating Bank Overdraft as a negative in Current Assets — it is a Current Liability and belongs in the denominator.
Applying the Quick Ratio ideal (1:1) to the Current Ratio, or vice versa — Current Ratio ideal is 2:1, Quick Ratio ideal is 1:1.
Omitting Provision for Taxation from Current Liabilities — it is a short-term obligation.
Using average stock in the balance sheet instead of closing stock when the question asks to prepare a balance sheet — balance sheets show closing (period-end) balances.
Confusing Quick Ratio with Absolute Cash Ratio: Quick Ratio includes debtors; Absolute Cash Ratio includes only cash and marketable securities.

Reference: Liquidity Ratios — Institute of Chartered Accountants of India

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Liquidity Ratios (Current, Quick, Cash)

Worked example

⚠️ Common exam mistakes