Liquidity refers to the company’s ability to meet its current financial obligations as and when they arise. Liquidity ratios are those which measure the company’s short term solvency and its ability to pay liabilities. There are basically two types of liquidity ratios which are used all over the world –
1. Current Ratio – It can be defined as ratio which measures the relationship between current assets and current liabilities. It is calculated as Current assets/Current liabilities. Current assets represent those assets which can be converted into cash within a period of one year while current liabilities represent those liabilities which have to be paid within a year. It is also called working capital ratio. An ideal current ratio should be 2:1 that is for every $1 of current liability there should be $2 of current assets.
2. Liquid Ratio – It is also known as acid test ratio or quick ratio. It is the ratio which measures the relationship between quick current assets and current liabilities. It is calculated as Quick assets/Current liabilities. Quick assets refer to current assets excluding inventory or stock and prepaid expenses. An ideal liquid ratio is 1:1 implying that for every $1 of current liabilities there should be $1 of quick assets so that company can pay the liabilities as and when they arise without any delay.