Define liquidity ratios.
Define
Liquidity Ratios:
The term Liquidity refers to the ability of the company to meet its current liabilities. Liquidity ratios assess capacity of the firm to repay its short term liabilities.
Thus, Liquidity ratios measure the firm's ability to fulfill short term commitments out of its liquid assets. The important liquidity ratios are:
1) Current ratio
2 ) Quick ratio
Current ratio:
Current ratio is a ratio between current assets and current liabilities of a firm for a particular period. This ratio establishes a relationship between current assets and current liabilities. The objective of computing this ratio is to measure the ability of the firm to meet its short term liability. It compares the current assets and current liabilities of the firm. The ratio is calculated as under:
Current Ratio = Current Assets / Current Liabilities
It indicates the amount of current assets available for repayment of current liabilities. Higher the ratio, the greater is the short term solvency of a firm and vice a versa.
However a very high ratio or very low ratio is a matter of concern. If the ratio is very high it means the current assets are lying idle. Very low ratio means the short term solvency of the firm is not good.
Thus, the ideal current ratio of a company is 2:1 i.e, to repay current liabilities, there should be twice current assets.
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