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Liquidity ratios are used to measure the ability of an entity to meet its financial obligations in the short term, that is, they are measures of the liquidity of a company. In simple terms, this translates to available cash or instruments that can easily realize cash. In this case, short term refers to a period of 12 months or less. Two of the most important liquidity ratios are the current index and the fast index. The latter, by definition, is a stricter liquidity measure, since it omits any element of current assets and current liabilities with the slightest illiquidity.
Required Resources:
– Balance of the company in question under study
– Notes to the financial statements, if necessary
Steps in the calculation:
1. Consider total current assets on the balance sheet. Depending on the discloser on the face of the accounts, you may need to look in the notes for the breakdown of current assets.
two. Restricted cash. From total current assets, deduct “restricted cash.” Such cash is not available for immediate use due to certain legal or other encumbrances.
3. Inventories. Deduct “inventories”. Accumulated salable goods can be liquefied only after a sale. Therefore, they may not be readily available when needed.
Four. Prepaid expenses. Subtract more the prepaid expenses from above. Although prepaid expenses are assets in the sense that they involve some defined future outflows already satisfied, they cannot be converted to cash, if necessary. It is extremely rare for third parties to reimburse advance payment for business expenses.
5. Get to ‘quick assets’ which generally include cash, cash equivalents (marketable securities) and accounts receivable / debtors.
6. Consider total current liabilities and their breakdown.
7. Bank overdraft. Subtract the bank overdraft from your total current liabilities. Bank overdrafts are drawn against lines of credit that generally extend for periods beyond one year and are often rolled over at maturity. More or less, these instruments become a permanent source of financing. As a common practice, bank overdrafts are not enforceable on demand, which adds a greater degree of permanence.
8. You get quick liabilities that generally include accounts receivable / creditors, current portion of long-term debt, income tax payable, and higher expenses of various kinds.
9. Use the formula for the final calculation to arrive at the ratio:
Quick ratio = quick assets / quick liabilities