Liquid or Liquidity Ratio / Acid Test or Quick Ratio:

Definition:

Liquid ratio is also termed as “Liquidity Ratio“,  “Acid Test Ratio” or “Quick Ratio“. It is the ratio of liquid assets to current liabilities. The true liquidity refers to the ability of a firm to pay its short term obligations as and when they become due.

Components:

The two components of liquid ratio (acid test ratio or quick ratio) are liquid assets and liquid liabilities. Liquid assets normally include cash, bank, sundry debtors, bills receivable and marketable securities or temporary investments. In other words they are current assets minus inventories (stock) and prepaid expenses. Inventories cannot be termed as liquid assets because it cannot be converted into cash immediately without a loss of value. In the same manner, prepaid expenses are also excluded from the list of liquid assets because they are not expected to be converted into cash. Similarly, Liquid liabilities means current liabilities i.e., sundry creditors, bills payable, outstanding expenses, short term advances, income taxpayable, dividends payable, and bank overdraft (only if payable on demand). Some time bank overdraft is not included in current liabilities, on the argument that bank overdraft is generally permanent way of financing and is not subject to be called on demand. In such cases overdraft will be excluded from current liabilities.

Liquid Ratio Formula / Acid Test Ratio:

[Liquid Ratio = Liquid Assets / Current Liabilities]

Example:

From the following information of a company, calculate liquid ratio. Cash $180; Debtors $1,420; inventory $1,800; Bills payable $270; Creditors $500 Accrued expenses $150; Tax payable $750.

Liquid Assets = 180 + 1,420 = 1.600

Current Liabilities = 270 + 500 + 150 + 750 = 1,670

Liquid Ratio = 1,600 / 1,670

= 0.958 : 1

Significance:

The quick ratio/acid test ratio is very useful in measuring the liquidity position of a firm. It measures the firm’s capacity to pay off current obligations immediately and is more rigorous test of liquidity than the current ratio. It is used as a complementary ratio to the current ratio. Liquid ratio is more rigorous test of liquidity than the current ratio because it eliminates inventories and prepaid expenses as a part of current assets. Usually a high liquid ratios an indication that the firm is liquid and has the ability to meet its current or liquid liabilities in time and on the other hand a low liquidity ratio represents that the firm’s liquidity position is not good. As a convention, generally, a quick ratio of “one to one” (1:1) is considered to be satisfactory.

Although liquidity ratio is more rigorous test of liquidity than the current ratio , yet it should be used cautiously and 1:1 standard should not be used blindly. A liquid ratio of 1:1 does not necessarily mean satisfactory liquidity position of the firm if all the debtors cannot be realized and cash is needed immediately to meet the current obligations. In the same manner, a low liquid ratio does not necessarily mean a bad liquidity position as inventories are not absolutely non-liquid. Hence, a firm having a high liquidity ratio may not have a satisfactory liquidity position if it has slow-paying debtors. On the other hand, A firm having a low liquid ratio may have a good liquidity position if it has a fast moving inventories. Though this ratio is definitely an improvement over current ratio, the interpretation of this ratio also suffers from the same limitations as of current ratio.

Absolute Liquid Ratio:

Absolute liquidity is represented by cash and near cash items. It is a ratio of absolute liquid assets to current liabilities. In the computation of this ratio only the absolute liquid assets are compared with the liquid liabilities. The absolute liquid assets are cash, bank and marketable securities. It is to be observed that receivables (debtors/accounts receivables and bills receivables) are eliminated from the list of liquid assets in order to obtain absolute4 liquid assets since there may be some doubt in their liquidity.

Formula of Absolute Liquid Ratio:

Absolute Liquid Ratio = Absolute Liquid Assets / Current Assets

This ratio gains much significance only when it is used in conjunction with the current and liquid ratios. A standard of 0.5 : 1 absolute liquidity ratio is considered an acceptable norm. That is, from the point of view of absolute liquidity, fifty cents worth of absolute liquid assets are considered sufficient for one dollar worth of liquid liabilities. However, this ratio is not in much use.

You may also be interested in other articles from “financial statement analysis” chapter:

1. Horizontal and Vertical Analysis
2. Ratios Analysis
3. Horizontal Analysis or Trend Analysis
4. Trend Percentage
5. Vertical Analysis
6. Accounting Ratios Definition, Advantages, Classification and Limitations:
7. Gross profit ratio
8. Net profit ratio
9. Operating ratio
10. Expense ratio
11. Return on shareholders investment or net worth
12. Return on equity capital
13. Return on capital employed (ROCE) Ratio
14. Dividend yield ratio
15. Dividend payout ratio
16. Earnings Per Share (EPS) Ratio
17. Price earning ratio
18. Current ratio
19. Liquid/Acid test/Quick ratio
20. Inventory/Stock turnover ratio
21. Debtors/Receivables turnover ratio
22. Average collection period
23. Creditors/Payable turnover ratio
24. Working capital turnover ratio
25. Fixed assets turnover ratio
26. Over and under trading
27. Debt-to-equity ratio
28. Proprietary or Equity ratio
29. Ratio of fixed assets to shareholders funds
30. Ratio of current assets to shareholders funds
31. Interest coverage ratio
32. Capital gearing ratio
33. Over and under capitalization
34. Financial-Accounting- Ratios Formulas
35. Limitations of Financial Statement Analysis

Other Related Accounting Articles:

• Acid Test Ratio
• Net Profit Ratio (NP Ratio)
• Accounting Ratios | Financial Ratios
• Efficiency Ratio
• Financial Ratios: Figures that keep you informed
• Analysis of Current Ratio
• Activity Ratios
• Defensive Interval Ratio
• Key Ratio
• Limitations of Ratio Analysis