Question -
Answer -
For determining the short-term solvency of a business liquidity ratios are essential. There are two types of liquidity ratios:
1. Current Ratio
2. Liquid Ratio/ Quick Ratio
1. Current Ratio: This ratio deals with the relationship between current assets and liabilities. It is calculated as:
Current assets are those assets which can be easily converted into cash whereas Current liabilities are liabilities that need to paid within that accounting period
Importance of Current Ratio
Current ratio helps in determining a firm’s ability to pay off the current liabilities on time. If there is more of current assets as compared to current liabilities, it provides a source of security to the creditors. The ideal ratio is 2:1 (Current Assets: Current Liabilities)
2. Liquid Ratio– It deals with the relationship between liquid assets and current liabilities. This ratio determines if the firm has sufficient funds for paying off the current liabilities on an immediate basis. It can be calculated as:
Importance of Liquid Ratio
It is helpful in determining if a firm has funds that can be sufficient to pay off liabilities. It does not include stock or prepaid expenses as both these are not easily converted to cash. A ratio of 1:1 is ideal for maintaining the liquid ratio.