Which ratio measures the ability of the firm to meet its short term obligations as and when they are due without relying upon the Realisation of stock and debtors?

Liquidity is the ability of a firm to meet its liabilities and pay its bills. A firm is liquid if it can pay its bills, illiquid if it cannot. Liquidity ratios measure the short term financial health of the business.

Working capital is the lifeblood of an organisation:

• too little and the firm may not be able to pay its debts, which may end in closure

• too much shows the business is not using financial resources efficiently

There are two liquidity ratios: the current ratio and the acid-test ratio.

The current ratio reflects the firm’s working capital position and its ability to pay its short-term creditors from the realisation of its current assets without selling any fixed assets. It is simply the ratio of all current assets to current liabilities:

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Current ratio  =current assets (stock + debtors + cash)current liabilities (creditors + overdrafts + short-term loans) × 100 \textsf{Current ratio} \space \space = \dfrac{\textsf{current assets (stock + debtors + cash)}}{\textsf{current liabilities (creditors + overdrafts + short-term loans)} } \space \textsf{×} \space \textsf{100}Current ratio  =current liabilities (creditors + overdrafts + short-term loans)current assets (stock + debtors + cash)​ × 100

Ideally, the figure should be greater than 1, indicating sufficient assets to pay liabilities. The rule of thumb is between 1.5 and 2.0. In other words, for every $1 of debts, the firm will have between $1.50 and $2 in current assets to pay for these. The higher the figure, the more liquid the business, but too high a figure indicates it may not be investing sufficiently in higher earning assets.

The current ratio includes stock, which may include redundant stock. It is best to ignore stocks when looking at liquidity.

The acid-test ratio is the strictest test of liquidity.

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Acid-test ratio  =current assets − stockcurrent liabilities × 100 \textsf{Acid-test ratio} \space \space = \dfrac{\textsf{current assets − stock}}{\textsf{current liabilities} } \space \textrm{×} \space \textsf{100}Acid-test ratio  =current liabilitiescurrent assets − stock​ × 100

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Acid-test ratio  =cash + debtorscurrent liabilities × 100 \textsf{Acid-test ratio} \space \space = \dfrac{\textsf{cash + debtors}}{\textsf{current liabilities} } \space \textrm{×} \space \textsf{100}Acid-test ratio  =current liabilitiescash + debtors​ × 100

This ratio measures the risk of bankruptcy, which increases as the value of the ratio falls. A value of 1.0 is considered satisfactory because the firm has sufficient liquid assets to meet its liabilities. Much below 1.0 is generally dangerous, whereas ratios above 1.0 may be a sign of poor cash management.

This ratio is industry-dependent. Major supermarkets may have seemingly ‘poor’ acid-test scores but quick stock turnover and good credit terms ensure adequate liquidity.