Liquidity ratios are used to measure an entity’s ability to fulfill its financial obligations in the short-term, i.e. they are measures of a firm’s liquidity. In layman terms, this translates into ready cash or instruments that can realize cash readily. Short-term here refers to a period of 12 months or less. Two of the most important liquidity ratios are the Current Ratio and the Quick Ratio. The latter, by definition, is a more stringent measure of liquidity as it omits outs any element out of the current assets and current liabilities with the slightest of illiquidity. Like Current Ratio, Quick Ratio is also a Balance Sheet analysis tool.
1. Consider the total current assets on the balance sheet. Depending upon the disclosure on the face of the accounts, you might have to look into the notes for breakup of the current assets.
2. Restricted Cash. Out of the total current assets, deduct ‘restricted cash.’ Such cash is not available for immediate use due to certain statutory or other encumbrance.
3. Inventories. Deduct ‘inventories.’ The accumulated saleable goods can be liquefied only upon a sale. Therefore, they may not be readily realizable as and when needed.
4. Prepaid Expenses. Further subtract prepaid expenses from above. Though prepaid expenses are assets in that they imply some definite future outflows already met, they cannot be converted into cash, if required. It is extremely rare that advance payment for business expenses are refunded by the third parties.
5. You arrive at the ‘quick assets’ that typically include cash, cash equivalents (marketable securities), and accounts receivable/debtors.
6. Consider total current liabilities and its breakup.
7. Bank Overdraft. Subtract bank overdraft from the total current liabilities. Bank overdrafts are drawn against credit lines that usually extend for periods beyond a year and are often renewed on expiry. More or less, these instruments become a permanent source of financing. As a common practice, bank overdrafts are not callable on demand, adding a further degree of permanence.
8. You get quick liabilities that typically include accounts receivable/creditors, current portion of long-term debt, income tax payable, and accrued expenses of various types.
9. Use formula for final calculation to arrive at the ratio:
Quick Ratio = Quick Assets/Quick Liabilities
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