Question

How does the Current/Quick/Cash ratios differ?

Answer 1

What is liquidity or short term solvency?

It’s a ratio which tells one’s ability to pay off its debt as and when they become due in short term. In other words, we can say this ratio tells how quickly a company can convert its current assets into cash so that it can pay off its short term liability on a timely basis..

Types of liquidity ratios

Under liquidity ratio there are several more ratios, which come into the picture for checking how financially, sound a company is:

I. Current Ratio

II. Acid Test Ratio or Quick Ratio

III. Absolute Liquidity Ratio or Cash Ratio

IV. Basic Defense Ratio

1. MEANING

Meaning of Current Ratio

Current ratio is the proportion of current assets to current liabilities.

Meaning of Quick Ratio

It is the ratio of quick (or liquid) asset to current liabilities.

Meaning of Cash Ratio

It shows the relationship between absolute liquid or super quick current assets and liabilities.

2. FORMULAS

Formula of Current Ratio It is expressed as follows:

Current Ratio = Current Assets

                            Current Liabilities

Current assets include current investments, inventories, trade receivables (debtors and bills receivables), cash and cash equivalents, short-term loans and advances and other current assets such as prepaid expenses, advance tax and accrued income, etc. Current liabilities include short-term borrowings, trade payables (creditors and bills payables), other current liabilities and short-term provisions.

Formula of Quick Ratio It is expressed as

Quick ratio =         Quick Assets        .                

         Current Liabilities

The quick assets are defined as those assets which are quickly convertible into cash. While calculating quick assets we exclude the inventories at the end and other current assets such as prepaid expenses, advance tax, etc., from the current assets.

Formula of Cash Ratio :

Cash ratio/ Absolute liquid ratio = Absolute liquid assets

                 Current liabilities

Absolute liquid assets include cash, bank balances, and marketable securities.

3. IDEAL RATIOS

Ideal of Current Ratio is 2:1

Ideal of Quick Ratio is 1:1

Ideal of Cash Ratio 1:2

4. PURPOSE OF RATIOS

Purpose of Current Ratio: It is calculated to check whether the current assets are sufficient to meet short term liabilities.

Purpose of Quick ratio: Because of exclusion of non-liquid current assets it is considered better than current ratio as a measure of liquidity position of the business. It is calculated to serve as a supplementary check on liquidity position of the business and is therefore, also known as ‘Acid-Test Ratio’

Purpose of Cash ratio: It is calculated to check whether the firm is able to pay its current liabilities from available liquid cash.