Question

Both the current ratio and quick ratio are used to measure the liquidity of company. Explain how the quick ratio overcomes the limitation of the current ratio. As a part of your answer discuss how the composition of current assets/liabilities impacts a firm’s liquidity position. (word limit 150)

Answer 1

INTRODUCTION

CURRENT RATIO- MEASURES THE ABLITY TO PAY THE CUREENT LIABILITY BY SELLING CURRENT ASSETES OF THE FIRM.

QUICK RATIO - MEASURES THE ABILITY TO PAY THE QUICK LIABILITY BY SELLING QUICK ASSETES OF THE FIRM.

ANS OF PART 1

THE QUICK RATIO OVERCOMES THE LIMITATION OF CURRENT RATIO ARE AS FOLLOWS,

1.INVENTORY

WHEN WE CALCULATE THE CURRENT RATIO, WE CONSIDER THE INVENTORY AS A CURRENT ASSETES , BUT IN REALITY IS NOT AN ASSTES IT IS BURDEN FOR THE COMPANY . DUE TO HIGHER INVENTOTRY THE PROFITABLITY IS LOW. IF THE PROFITABLITY IS LOW HOW A COMPANY CAN SUSTAIN FOR LONG RUN. SO IN SHORT WE CAN SAY THE TAKING THE INVENTORY IN COMPUTING CURRENT RATIO IS A LIMITATION OF CURRENT RATIO BECAUSE IT DOESNOT GIVE THE PROPER PICTURE OF LIQUIDITY.

IN THE OTHER HAND QUICK RATIO HAS REMOVED THIS LIMITATION. WHEN WE COMPUTING THE QUICK ASSTES WE DEDUCT THE INVENTORY BY THIS WE GET THE ACTUAL PICTURE OF QUICK ASSTES THAT CAN BE COVERTABLE IN CASH QUICKLY FOR PAYING QUICK LIABILITY.

2. PREPAID EXPENSE:-

PREPAID EXPENSE MEANS WHICHT I PAID IN ADVANCE BUT CONSUMPITION IS STILL REMAIN . IN THE FINANCIAL STATEMENT UNDER THE CURRENT ASSTES HEAD PREPAID EXPENSE IS ALSO THERE. WHWN WE CALCULATING THE CURRENT RATIO IT TAKES INTO THE ACCOUNT. BUT THE LIMITATION IS COMING HERE THAT WE COULD NOT SELL THIS KIND OF ASSTES . IT MEANS THAT IT DOESNT HAVE ANY SELLING VALUE. IN A SHORT WE CAN SAY THAT PREPAID EXPENSE IS FICTICIOUS ASSTES OF THE COMPANY. WHEN TAKING INTO THE CALCULATION OF CURRENT ASSTES IT DOESNOT REFELCT THE ACTUAL POSITION OF LIQUIDTY

IN THE OTHER HAND QUICK RATIO HAS REMOVED THIS LIMITATION . WHEN WE COMPUATAING THE QUICK ASSES WE DEDUCT THE PREPAID EXPENSE BY THIS WE GET ACTUAL PICTURE OF LIQUIDTY.

FROM THE ABOVE DISCUSSION WE MAY CONCLUDE THAT QUICK RATIO IS BETTER PREDICTOR OF LIQUIDITY THAN THE CURRENT RATIO.

ANS OF PART 2:-

FOR ANSERING THIS PART WE HAVE TO KNOW THE WHAT IS CURRENT ASSTES AND WHAT IS CUURENT LIABILITITES??

CURRENT ASSTES ARE THOSE ASSTES WHICH CAN BE CONVERTABLE INTO CASH WITHIN A YEAR & CURRENT LIABILITIES ARE THOSE LIABILITIES WHICH MUST BE PAID WITHIN A YEAR.

THOUGHT PROCESS OF CURRENT RATIO

THE MEASUREMENT POLICY OF CURRENT RATIO IS GIVEN BELOW,

1. IF A COMPANY HAS MORE CURRENT ASSTES THAN THE CURRENT LIABLITY THE COMPANY'S LIQUIDITY MEASURES IS GOOD. OR THE COMPANY HAS IN A SOLVENT POSITION TO MEET THEIR CURRENT LIABILITY .

2. IF A COMPANY HAS LOW CURRENT ASSTES THAN THE CURRENT LIABILITY IT COULD NOT MEET THEIR CURRENT LIABILITY IN ANY SITUATION. FOR THE MET THE CURRENT KIABILITY COMPANY HAS TO DEPEND ON THE EXTENAL FUND.

IN SHORT MANNER CURRENT RATIO IS MEASURING THE LIQUIDTY ON THE PROPORTION OF CURRENT ASSTES & CURRENT LIABILITY. IT IS AN ANOTHER VIEW OF WORKING CAPITAL . WE KNOW THAT (CURRENT ASSTES - CURRENT LIABILITY)= WORKING CAPITAL. I WORKING CAPIATL IS POSTIVE IT IS GOOD INDCATOR. IF IT IS NEGATIVE THE COMPANY DO NOT MEET THE DAY TO DAY EXPENSE OF THE COMAPANY.

WE MAY CONCLUDE OUR DISCUSSION AS THE CURRENT RATIO IS MEASURES THE LIQUIDITY POSITION OF ANY COMPANY IN THE VIEW POINT OF WORKING CAPITAL MEASURMENT. AND WE ALL KNOW THAT WORKING CAPITAL IS THE MOST BASICE MEASURES OF THE LIQUIDITY .