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Liquidity Ratio : UGC-NET Commerce Notes and Study Material!
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A liquidity ratio is used to determine a company's ability to pay its short-term debt obligations. The three main liquidity ratios are the current ratio, quick ratio, and cash ratio. A liquidity ratio helps us understand how easily a company can pay its bills. It indicates whether or not a business has sufficient cash or other liquid assets to cover its short-term obligations. Businesses need cash to pay for things such as rent, salaries, and supplies. The higher the liquidity ratio of a business, the more easily it will be able to pay its debts. If the ratio is low, the company may struggle to pay what it owes. Liquidity ratios are usually calculated using numbers from a company’s financial statements. Two common liquidity ratios are the current ratio and the quick ratio. The current ratio compares a company’s assets to its short-term debts. The quick ratio is more strict and only considers the most liquid assets. Both ratios help investors and business owners make smart decisions.
Liquidity ratios is a very vital topic to be studied for the competitive exams such as the UGC-NET Commerce Examination.
In this article, we delve into the various topics such as:
- What is Liquidity Ratio?
- Exploring Different Types of Liquidity Ratios
- Liquidity Coverage Ratio
- Formulas for Liquidity Ratio
What is Liquidity Ratio?
A liquidity ratio helps us know if a company can pay its short-term debts. It compares a company’s money or assets to what it owes. If the ratio is high, the company has enough money to pay its bills. If the ratio is low, the company may have trouble paying its debts. Liquidity ratios are important for businesses to stay healthy and avoid bankruptcy. There are two most popular liquidity ratios. Those are the current ratio and quick ratio. The former looks at all of a company's assets. The latter is only about cash and things that can be immediately turned into cash. These two ratios enable us to realize whether or not a company has enough money in its pockets to pay short-term bills. They depict the financial capability of a company whether it has sufficient ability to tackle all its short-term needs or not.
Exploring Different Types of Liquidity Ratios
Liquidity ratios allow us to determine the ability of a firm to pay its short-term bills. There are many kinds of liquidity ratios, and each looks at how a company might apply its cash to service debts. Some consider all the firm's assets; others focus solely on cash or highly liquid items. When we compare these ratios, we will determine if the company is financially sound and if it will pay its short-term bills in due time. The various types of liquidity ratios with formulas of liquidity ratios have been stated below.
Current Ratio (Working Capital Ratio)
The current ratio is a liquidity ratio that indicates a company’s ability to clear its debts within the next year. This ratio is a crucial metric for creditors when deciding whether to grant short-term loans to a company. It also gives insights into the company’s operating cycle. The current ratio, also known as the working capital ratio, is calculated by dividing the current assets by the current liabilities.
The formula for Current ratio is:
Current ratio = Current Assets / Current Liabilities
For most industries, a current ratio of around two is considered ideal, whereas a value less than one suggests that the company may struggle to meet its short-term liabilities.
Quick Ratio (Acid Test Ratio)
The quick ratio, also called the Acid Test ratio, shows if a company has enough assets that can quickly be turned into cash to pay its short-term debts. It is calculated by dividing the company’s liquid assets by its current debts.
The formula for Quick ratio is:
Quick Ratio = (Cash + Marketable securities + Accounts receivable) / Current liabilities
A quick ratio of one is considered ideal for a financially stable company.
Cash Ratio (Absolute Liquidity Ratio)
The cash ratio measures a company’s liquidity by assessing whether it can pay off debts using only its liquid assets (cash and cash equivalents such as marketable securities). Creditors use this ratio to determine the relative ease with which a company can clear short-term liabilities.
The formula for Cash ratio is:
Cash ratio = Cash and equivalent / Current liabilities
Net Working Capital Ratio
The net working capital ratio helps determine if a company has enough cash or funds to continue its operations. It is calculated by subtracting the current liabilities from the current assets.
Net Working Capital Ratio = Current Assets – Current Liabilities
Liquidity Coverage Ratio
The Liquidity Coverage Ratio, or LCR, is a Basel Committee rule to ensure that banks maintain sufficient cash or other liquid assets. This will help banks in hard times because they will be able to handle their problems for 30 days. It ensures that banks maintain enough liquid assets, which are things they can quickly turn into cash, in case of a financial emergency.
Conclusion
Management theories help businesses work better by guiding how to lead and organize. These theories teach managers how to motivate workers and improve teamwork. They also help solve problems and make decisions. With these theories, the manager can create a positive workplace, help staff members perform at their best, and achieve their goals. Indeed, different situations require different theories to be applied by the manager. In the final analysis, management theories help businesses grow and flourish.
Liquidity Ratio is a vital topic for the UGC NET Philosophy examination. It would help if you learn similar topics with the Testbook App.
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Major Takeaways for UGC NET Aspirants
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Liquidity Ratio Previous Year Questions
- What are the different types of liquidity ratio?
Options. A. Interest coverage ratio
- Current ratio
- Inventory turnover ratio
- Gross profit ratio
- Acid test ratio
Choose the correct answer from the options given below:
Options. A. A& B only
- B & E only
- B & D only
- More than one of the above
- None of the above
Ans. B. B & E only
Liquidity Ratio FAQs
What is SLR?
SLR is known as the statutory liquidity ratio. It is the minimum percentage of the deposit that a commercial bank needs to maintain in the form of cash, securities and gold before offering credit to customers. Current SLR is 21.50% in India.
What is Liquidity Coverage Ratio?
Liquid coverage ratio is the proportion of high liquid assets that banks need to maintain short term debts or liabilities.
What is a good liquidity ratio?
A good liquidity ratio can be any value that is greater than 1. It indicates that a company is having a sound financial position and can meet short-term obligations efficiently.
What are three types of liquidity ratios?
The three types of liquidity ratios are the current ratio, quick ratio and cash ratio. These are useful in determining the liquidity of a company.
What are the most common liquidity ratios
The most common liquidity ratios are the current ratio and quick ratio. These are very useful ratios for calculating a company’s ability to pay short term liabilities.
What are liquidity ratios, and why are they important for businesses?
Liquidity ratios are financial metrics that measure a company's ability to meet its short-term obligations. They are important for businesses because they provide insights into the organization's ability to cover immediate financial needs without disrupting regular operations. Adequate liquidity is crucial for maintaining financial health and meeting unexpected expenses.