## Liquidity Ratios (Short-term Solvency)
### What they measure
- Liquidity / short-term solvency = the business's ability to pay its short-term liabilities.
- Inability to pay erodes credibility and credit rating; continuous default can lead to commercial bankruptcy, then sickness and dissolution.
- Short-term lenders and creditors care most about liquidity because of their financial stake.
- Both too little and too much liquidity is bad — excess liquidity means idle, under-utilised funds.
### The liquidity ratios
(a) Current Ratio (b) Quick / Acid-test Ratio (c) Cash / Absolute Liquidity Ratio (d) Basic Defense Interval (e) Net Working Capital
### A. Current Ratio
$$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$
- Generally acceptable: 2 : 1 — but whether it is satisfactory depends on the nature of the business and the character of its current assets/liabilities.
- Current Assets = Inventories + Sundry Debtors + Cash & Bank Balances + Receivables/Accruals + Loans & Advances + Disposable Investments + any other current assets.
- Current Liabilities = Creditors for goods & services + Short-term Loans + Bank Overdraft + Cash Credit + Outstanding Expenses + Provision for Taxation + Proposed Dividend + Unclaimed Dividend + any other current liabilities.
### B. Quick Ratio (Acid-test Ratio)
One of the best measures of liquidity — it strips out the least-liquid current asset (inventory).
$$\text{Quick Ratio} = \frac{\text{Quick Assets}}{\text{Current Liabilities}}$$
- Acceptable standard: 1 : 1.
- Caveat: a 1:1 quick ratio is not satisfactory if most 'quick assets' are accounts receivable and the collection of those receivables lags behind the schedule for paying current liabilities.
> Exam tip: The benchmarks (2:1 current, 1:1 quick) are rules of thumb, not absolute targets — always qualify them with the nature of the business.