|Written by Sunil Tinani|
There are three broadly used liquidity ratios: (i) working capital; (ii) current ratio; and (iii) quick (acid) ratio.
1. Working Capital
Working Capital = Current Assets – Current Liabilities
This simple calculation can help the investor figure out if a company can meet its current business commitments. Current assets are assets that can be quickly converted into cash and current liabilities are liabilities that have to be repaid within a short span of time. If a company's current assets exceeds its liabilities, then it can meet its obligations in time; if its current assets equal its current liabilities, then its working capital is zero; if its current liabilities exceeds its current assets, then the company may have to look for funds to meet its current commitments – otherwise it may get into trouble. Thus, working capital reflects a company's immediate liquidity position.
2. Current Ratio
Current Ratio = Current Assets ÷ Current Liabilities
Current ratio is an extension of the working capital calculation and indicates how liquid a company is. A high ratio indicates liquidity, a ratio of 1 indicates that the company is living hand to mouth, and a ratio less than 1 indicates that the firm does not have enough immediate assets to cover its immediate liabilities.
3. Quick Ratio (also known as the Acid Test)
Quick Ratio = (Current Assets – Inventory of raw material, semi-finished and finished goods) ÷ Current Liabilities
The problem with current ratio is that it includes certain items that cannot be cashed quickly, and some items that may not be realizable in full. Quick Ratio is a measure of the immediate liquidity of a company that takes into account this factor.
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