Liquidity ratios determine a firm’s capability to satisfy its short term commitments. Existing ratio and fast ratio are the most frequently secondhand ratios for determining a firm’s liquidity position. It’s regularly stated that a present ratio of 2:1 and a fast ratio of 1:1 is maximum for a company.
In order to calculate current ratio and acid examination ratio (fast ratio) we’ve to comprehend the components of current assets, fast assets and present liabilities.
Components of Existing possessions, Quick assets and Present liabilities
Current assets consist of money, stock, accounts receivables, short term investments and prepaid costs. These assets are called existing possessions since they’re anticipated to be converted into money within a brief period of time (such as one year). For this reason, any investment which has a maturity duration of more than one year won’t be treated as current assets.
Quick assets include cash, accounts receivables and short-term financial investments. Stock and prepaid expenditures aren’t consisted of while figuring out total quick possessions. Stock is left out from the computation of current ratio due to the fact that it couldn’t be possible to convert stock into cash as quickly as other possessions. Similarly prepaid expenditures are excluded since such expenditures have actually currently been incurred by the business. It’s important to note that prepaid costs couldn’t be exchanged for money.
Current Liabilities include accounts payables and short term outstanding liabilities. Details on existing liabilities is available on the liability side of balance sheet. It’s necessary to keep in mind that current liabilities are anticipated to be settled within a period one year. Hence, any quantity of debt which has a payment period of more than one year won’t be considered as an existing liability.
Formula for Calculating Current Ratio and Quick Ratio is as follows:
Current Assets/Current Liabilities
(Existing Assets – Inventory – Prepaid Expenditures)/ Current Liabilities or (Money + Accounts Receivables + Short-term financial investments)/ Existing Liabilities
Information for figuring out current ratio and fast ratio is readily available in the balance sheet of any business.
Calculation of Current and Quick Ratio
Let’s comprehend the calculation of these two liquidity ratios with the assistance of an instance.
Following info is offered from the balance slab of XYZ Ltd.
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Land and Building $ 85,000, Plant and Equipment $ 75,000, Cash $ 10,000,
Cash at bank $ 40,000, Inventory $ 30,000, Sundry Debtors $ 90,000, Sundry Creditors $ 70,000, Superior rent $ 30,000, Prepaid Expenditures: $ 5,000.
With the help of above mentioned figures, existing ratio and quick ratio could be figured out as follows:
Total Existing Possessions = $ 10,000 (Cash) + $ 40,000 (Money at bank) + $ 30,000 (Inventory) + $ 90,000(Sundry Debtors) + $ 5,000 (Prepaid Costs) = $ 1, 75,000
Total Quick Possessions = $ 10,000 (Cash in hand) + $ 40,000 (Cash at bank) + $ 90,000 (Sundry Debtors) = $ 1, 40,000
Total Current Liabilities = $ 70,000 (Sundry Creditors) + $ 30,000 (Exceptional Rent) = $ 1, 00,000
Current Ratio = $ 1, 75,000 (Total Current Possessions)/$ 1, 00,000 (Overall Current Liabilities) = 1.75:1
Quick Ratio = $ 1, 40,000 (Overall Quick Assets)/ $ 1, 00,000 (Overall Current Liabilities) = 1.4:1
A reduction in the worth of any current liability would typically cause a matching reduction in the worth of a present asset. For Instance, a payment of $ 10,000 to a sundry creditor in the above example would result in a reduction of $ 10,000 in the cash balance of the business. As a result, cash will come down to no while sundry creditors would come down to $ 60,000. Overall current assets would boil down to $ 1, 65,000 while overall existing liabilities would boil down to $ 90,000. Quick possessions will boil down to $ 1, 30,000. Current ratio and fast ratio would be 1.83 and 1.44 respectively.