Liquidity Ratios in Accounting 🥇 Defined for Dummies | SA Shares

What’s a liquidity ratio?

A liquidity ratio is a monetary ratio utilized in accounting[i] to judge a enterprise’s skill to pay its short-term debt obligations, additionally referred to as present liabilities, with its present property.

 

Forms of liquidity ratios

Liquidity ratios comprise the next ratios:

  • Present ratio/Working capital ratio
  • Fast ratio/Acid check ratio
  • Money ratio
  • Working money circulate ratio

 

Present ratio

What the present ratio measures

The present ratio measures a enterprise’s skill to repay its short-term liabilities with its present property.

The ratio will also be categorized beneath the exercise ratios because the working capital ratio.

Quick-term liabilities, additionally referred to as present liabilities, are debt obligations that must be paid inside one yr. Present liabilities are reported on the steadiness sheet of a enterprise.

 

Examples of short-term liabilities:

  • Accrued bills
  • Accounts payable (Additionally known as payables)
  • Quick-term loans
  • Checking account overdrafts
  • Curiosity payable
  • Earnings taxes payable
  • Dividends payable
  • Buyer deposits
  • Present portion of long-term money owed

 

Present property, additionally referred to as present accounts or liquid property, are money and different property of a enterprise which might be anticipated to be transformed to money inside one yr. Present property are reported on an organization’s steadiness sheet.

 

Examples of present property:

  • Money and money equivalents, reminiscent of cash market devices
  • Stock
  • Accounts receivable (Additionally referred to as receivables)
  • Pay as you go bills
  • Quick-term investments
  • Marketable securities

 

Present ratio = Present Property/Present liabilities

  • Instance of the present ratio

If firm Image Excellent’s present property are R1 200 000 and its present liabilities are R400 000, its present ratio will look as follows:

R1 200 000/R400 000

= 3:1

Thus, the corporate will have the ability to repay its short-term debt obligations 3 occasions with its present property obtainable.

The upper the present ratio, the higher a enterprise’s liquidity place, and vice versa.

 

Fast ratio

What the short ratio signifies

The fast ratio, also referred to as the acid check ratio, signifies whether or not a enterprise can fulfill its present liabilities with its most liquid present property reminiscent of money, money equivalents, accounts receivable, and short-term marketable securities.

Put in another way, the short ratio excludes much less liquid present property like stock and pay as you go bills, making it a stricter check of a enterprise’s liquidity than the present ratio.

 

Fast ratio = (Present property – Stock – Pay as you go bills)/Present liabilities

  • Instance of the short ratio

Allow us to take firm Image Excellent with its R1 200 000 present property and R400 000 present liabilities once more for instance.

Included within the present property are a list of R350 000 and pay as you go bills of R50 000.

Firm Image Excellent’s fast ratio will no be calculated within the following approach:

Fast ratio = (R 1 200 000 – R350 000 – R50 000)/R400 000

= R800 000/R400 000

= 2:1

The corporate’s present ratio is 3:1. Nonetheless, the short ratio of two:1, which is the stricter liquidity check of the 2 ratios, exhibits that the corporate will solely have the ability to repay its present liabilities 2 occasions (and never 3 occasions) with its present property obtainable.

 

Money ratio

What the money ratio exhibits

The money ratio, additionally known as the money asset ratio, solely takes a enterprise’s most liquid present property, particularly money and money equivalents, into consideration when it determines whether or not a enterprise will have the ability to repay its present liabilities.

Money equivalents embody liquid property like cash market devices and marketable securities.

The money ratio is the most conservative and strict ratio of the three ratios (present ratio, fast ratio, and money ratio).

 

(Money + Money equivalents)/Present liabilities

  • Instance of the money ratio

Firm Image Excellent is once more taken for instance to reveal the variations between the three liquidity ratios.

As already talked about, the corporate has R400 000 present liabilities on its books. Included in its present property of R1 200 000 are money of R250 000 and money equivalents of R150 000.

Image Excellent’s money ratio will look as follows:

(R250 000 + R150 000)/R400 000

= R400 000/R400 000

= 1:1

Thus, the money ratio exhibits that the corporate will solely simply handle to repay its short-term debt obligations.

 

Working money circulate (OCF) ratio

What the OCF ratio determines

The working money circulate (OCF) ratio is a liquidity ratio that determines how effectively a enterprise can repay its present liabilities with the amount of money generated by its regular enterprise operations.

Specific, in different phrases, the OCF ratio signifies how a lot a enterprise earns from its working actions per rand (ZAR) or US greenback of its present liabilities throughout a selected accounting interval reminiscent of 1 / 4 or a yr.

A enterprise’s money circulate from operations might be discovered on its assertion of money flows.

 

Working money circulate ratio = Working money circulate/Present liabilities

  • Instance of the working money circulate ratio

The next info was obtained from firm BBB’s annual monetary statements:

  • Working money circulate: R750 000
  • Present liabilities: R600 000

Calculation of BBB’s working money circulate ratio:

R750 000/R600 000

= 1.25

Therefore, firm BBB will have the ability to cowl its present liabilities 1.25 occasions with the money generated from its working actions. Put in another way, the corporate earns R1.25 from its working actions, per rand (ZAR) of its present liabilities.

 

Why are liquidity ratios essential?

Liquidity ratios are essential monetary instruments in accounting.[ii] The ratios are helpful for:

  • Collectors, reminiscent of suppliers, to find out if a enterprise can cowl its short-term debt obligations.
  • Lenders when deciding whether or not they need to prolong credit score to a enterprise.

Buyers when analysing an organization’s ‘funding worthiness’, making certain that an organization is financially wholesome.

 

[i] Confer with the article, ‘Accounting Ratios Defined for Dummies’, for an outline of the quite a few ratios utilized in accounting.

[ii] See the article, ‘Accounting Defined for Dummies’, for extra details about accounting typically.



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