Liquidity Ratios

Returning to the Balance Sheet, Liquidity ratios help to determine the ability of a business to meet its day to day obligations. Since these obligations will often include repayment of bank loans, this can be very important for the banker.

Initially, we generally calculate two simple liquidity ratios, as illustrated next, from the balance sheet.

Liquidity ratios:

Liquidity ratios

The current ratio indicates the ability of the business to meet short term obligations from current assets. However, this involves making the broad assumption that current assets can be converted in a relatively short time into cash if required to meet some or all of the current liabilities.

We may find it useful to look at the trend in this ratio over time or compare the ratio from a particular business with an accepted safe norm for the industry. Broadly speaking, manufacturing industries should have a much stronger current ratio (2 is often considered a safe norm) than a cash business such as a retail shop or restaurant.

The Quick Asset Ratio eliminates the reliance on sale of stock in discharging liabilities to short term creditors. A low or deteriorating ratio should at least prompt us to ask questions about the ability of the business to withstand any liquidity problems.

Before drawing any definitive conclusions from an assessment of these primary liquidity ratios, it is advisable to examine Stock, Debtors and Creditors in more detail. These are the main determinants of the need for Working Capital, so ratios involving these items are often called the Working Capital Ratios.