This document discusses accounting ratios, specifically liquidity ratios. It defines liquidity ratios as ratios that assess a firm's ability to pay current liabilities. Two key liquidity ratios are discussed in detail: The current ratio compares current assets to current liabilities and measures a firm's ability to pay off current debts with current assets. A ratio of 2:1 is generally considered adequate. The quick ratio compares more liquid current assets (excluding inventory and prepaid expenses) to current liabilities and measures a firm's ability to pay current debts within a month. A ratio of 1:1 is generally considered adequate. The document provides the detailed formulas and interpretations of these two important liquidity ratios.

1. Accounting Ratios
Liquidity Ratios
By:- Deepak Madan
PGT- Comm

2. Introduction
• Absolute figures expressed in monetary terms
in financial statements by themselves are
meaningless. These figures often do not
convey much meaning unless expressed in
relation to other figures.
To make it meaningful we represent
accounting information in relation to other. This
relation between two figures ,expressed in
arithmetical terms is called a ‘ratio’

3. Ways to express Ratios
• Pure ratios: -
Are expressed by simple division of one number by another,
also called proportion or simple ratio. E.g. 1/5
• Rate or So many times: -
In this type, it is calculated how many times a figure is, in
comparison to another figure. E.g. 5 times
• Percentage ratios:-
In this relation is expressed in terms of hundredth. E. g. 20%
• Fraction:
In terms of more or less. E.g.- project 1 is more beneficial than
project 2

4. Types of Ratios
Liquidity Ratio Solvency Ratio
Activity or
Turnover Ratio
Profitability
Ratio
Ratios

5. Liquidity Ratio
• Liquidity refers to the ability to pay the
current liabilities of the firm. So these are also
called ‘short term solvency ratios.
• Liquidity ratios of the firm are assessed to
know the margin between current assets and
current liability
−

7. Current Ratio or Working Capital Ratio
Meaning It explains the relationship between current assets and current
liabilities
Formula Current Assets/Current Liabilities
Current Assets: - Current Investments+ Inventories+ Trade Receivables(Less
Provision)+ Cash& Cash Equivalent + Short term Loans and
Advances + Other current Assets( Prepaid Expenses + accrued
incomes + advance tax)
Current Liabilities Short term Borrowings(including Bank Overdraft) Trade Payables +
Other Current liabilities ( Unpaid Dividends + Interest accrued on
borrowings + Income Received in Advance + Outstanding
Expenses) +Short term Provisions( Provision for Tax + Proposed
Dividends )
Significance 2:1

8. Adverse Effect of Higher Ratio From Management Point Of
View
• A much higher ratio may indicate inventory may
be piling up due to poor sale.
• Trade receivable is in excess due to inefficient
collection policy.
• Cash or bank balance may be lying idle because
of improper investment opportunity.

9. Points to be considered while calculating Current
Ratio.
• Only those assets, which have some realizable value with in
one year, should be considered.
• Only those liabilities which are payable with in one year should
be considered. Even debentures or long-term liabilities which
are payable with in the year should be treated as current
liabilities.
• Term investment is treated as non-current investment.
• Current investment, short-term investment and marketable
securities are treated as current assets.
• Loose tools, patents, Goodwill, Trade Marks and Computer
Software are not included in current assets.
• Bank Overdraft is treated as current liability.
• Loan, Loan on Mortgage and Bank Loan are treated non current
liability.

10. Quick Ratio or Acid Test Ratio or Liquid Ratio
CurrentRatioorWorkingCapitalRatioMeaning It indicates weather the firm is in position to pay its current
liability with in a month.
Formula Liquid Assets/Current Liabilities
Liquid or Quick
Assets: -
All current assets except inventory and prepaid expenses
Current Liabilities Short term Borrowings(including Bank Overdraft) Trade Payables +
Other Current liabilities ( Unpaid Dividends + Interest accrued on
borrowings + Income Received in Advance + Outstanding
Expenses) +Short term Provisions( Provision for Tax + Proposed
Dividends )
Significance 1:1

11. Test Your Knowledge
• Current ratio of a company is 2:1. which of the following
suggestions would improve the ratio, which would reduce it
and which would not change it?
1. Purchase of goods on credit.
2. Purchase of goods on cash.
3. Sold goods costing Rs.50000 for Rs. 60000 on credit.
4. To sell a fixed asset on a slight loss.
5. To borrow money on a promissory note (B/P).
6. To give Promissory Note to a creditor