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Question:

What are liquidity ratios? Discuss the importance of current and liquid ratio.

Answer:

Liquidity ratios are calculated to determine the short-term solvency of a business, i.e. the ability of the business to pay back its current dues. Liquidity means easy conversion of assets into cash without any significant loss and delay. Short-term creditors are interested in ascertaining liquidity ratios for timely payment of their debts.

Liquidity ratio includes:

Current Ratio: It explains the relationship between current assets and current
liabilities. It is calculated as:

Current Ratio = Current Assets/Current Liabilities

Liquid Ratio or Quick Ratio: It explains the relationship between liquid assets and current liabilities. It indicates whether a firm has sufficient funds to pay its current liabilities immediately. It is calculated as:

Liquid Ratio = Liquid Asset/Current LiabilitiesLiquid

Liquids Assets = Current Assets – Stock – Prepaid Expenses.


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