LIQUIDITY AND ITS TEST
Meaning
• Liquidity refers to the ability of a firm to meet its obligations in the
short term usually ONE YEAR.
• A firm can maintain liquidity if it holds assets that could be quickly
sold with minimum transaction cost and loss in value.
• The test of liquidity is the ability of the firm to meet its cash
obligations when they are due and to exploit sudden opportunities in
the market.
Factors determining Liquidity
• Certainty of Cash flow pattern.
• Maturity schedule of its current obligations
• Availability of inventories at right time and right place
• Ability to procure extra funds in case of needs
• Ability to meet its cash obligations
• Utilization of un-availed credit limits
• Enhancement of cash credit limits
• Minimization of cost of financing.
• Ability to raise non bank funds
Factors determining Liquidity
• Efficiency of Cash management
• Ability to speed up the collection of accounts receivable
• Ability to defer payment of bills.
Measurement of Liquidity
• LIQUIDITY RATIOS
1. Current ratio – Current Assets/Current liabilities
2. Liquid ratio (ACID TEST RATIO) : Cash + Marketable securities +
receivables/Current Liabilities
OR
Current Assets –(Inventories + Prepaid Expenses)/ Current
liabilities
3. QUICK Ratio (Absolute Liquid Ratio) : Cash + Marketable
securities/Current liabilities
Measurement of Liquidity
• TURNOVER RATIOS
1. Stock Turnover Ratio: Cost of Goods sold/Average inventory
2. Debtor receivable turnover ratio: Net Credit annual Sales/ Average
trade Debtors
3. Creditors Turnover ratio: Net credit annual purchases/ Average
Trade Creditors
Compute Current Ratio
Liabilities Amount Rs Assets Amount Rs
Sundry Creditors 40,000 Inventories 1,20,000
Bills Payable 30,000 Sundry Debtors 1,40,000
Dividend Payable 36,000 Cash at Bank 40,000
Accrued Expenses 14,000 Bills receivables 60,000
Short Term 50,000 Prepaid Expenses 20,000
Advances Machinery 2,00,000
Share Capital 1,50,000 Land & Building 1,50,000
Debentures 2,00,000
Compute Acid Test Ratio
Liabilities Amount Rs
Current Assets 40,00,000
Liquid Liabilities 20,00,000
Inventories 2,50,000
Prepaid Expenses 2,50,000
Land & Building 40,00,000
Share Capital 30,00,000
Goodwill 20,00,000
Compute Absolute Liquid ratio
Liabilities Amount Rs Assets Amount Rs
Bills Payable 3,00,000 Goodwill 20,00,000
Sundry Creditors 2,00,000 Land & Building 20,00,000
Share Capital 10,00,000 Inventories 5,00,000
Debentures 20,00,000 Cash in Hand 3,00,000
Bank Overdraft 2,50,000 Cash at Bank 2,00,000
Sundry Debtors 5,00,000
Bills Receivables 7,50,000
Marketable 1,00,000
Securities
Numerical
• Find out
• CURRENT ASSETS
• CURRENT LIABILITIES
• LIQUID ASSETS
• STOCK
• FROM
• CURRENT RATIO = 2.8:1
• ACID TEST RATIO = 1.5:1
• WORKING CAPITAL = Rs 1,62,000
Short term solvency position -ACTIVITY RATIOS
• Activity ratios reflects the intensity with which company uses assets
in generating sales
• Indicates whether Company’s investment in current assets and fixed
assets is too small or too large
• If too large, excess funds are tied up, leading to sub optimum
utilization of assets
• If too small, may be providing poor service to customers or
production is inefficient.
Short term solvency position -ACTIVITY RATIOS
• Receivable Turnover
• Both Current Ratio and Acid test Ratio assumes that Sundry Debtors
can be converted into cash within enough time to allow the payment
of current liabilities.
• Balance must be struck in creation of Sundry Debtors.
• Debtors Turnover = Total net sales or credit sales/Average net
debtors = A
• Av Net debtors = (Opening debtors + Closing Debtors)/2
• Average Collection Period = Number of days in a year/ A (Debtors
turnover Ratio)
Short term solvency position -ACTIVITY RATIOS
• ALTERNATIVELY
• Average Collection Period = Number of days in a year * Average
Debtors/ TOTAL Credit Sales
Balance sheet as on 31.03.2021
Liabilities Amount Rs Assets Amount Rs
Sundry Creditors 40,000 Inventories 1,20,000
Bills Payable 30,000 Sundry Debtors 6,00,000
Dividend Payable 36,000 Cash at Bank 40,000
Accrued Expenses 14,000 Bills receivables 60,000
Short Term 50,000 Prepaid Expenses 20,000
Advances Machinery 2,00,000
Share Capital 1,50,000 Land & Building 1,50,000
Debentures 2,00,000
Short term solvency position -ACTIVITY RATIOS
• Sales during the year are 1,00,00,000
• Cash Sales = 20%
• Sundry Debtors as on 31.12.2020 = Rs, 5,60,000
• Compute Average Collection period
Short term solvency position -ACTIVITY RATIOS
• Debtors Turnover ratio = 80,00,000/ (5,60,000+6,00,000)/2
• = 13.8 times
• Average collection period = Number of days in a year/Debtors
turnover Ratio
• = 365/13.8
• = 26.45 days
• 580000/8000000 = 0.0725
• Av collection period = 365 * 0.725 = 26.45 days
Short term solvency position -ACTIVITY RATIOS
• Inventory Turnover Ratio
• Is a measure of number of times the average inventory has been sold during the
year.
• Inventory Turnover Ratio = Cost of goods sold/ Average inventory.
• Cost of goods sold = is the direct cost of making a product. IT DOES NOT INCLUDE
INDIRECT COST
• COGS = SALES- GROSS PROFIT
• OR
• DIRECT EXPENSES + OPENING STOCK – CLOSING STOCK
• Average inventory turnover days = Number of days in a year/Inventory Turnover
ratio
Compute Inventory Turnover Ratio
Balance sheet as on 31.03.2021
Liabilities Amount Rs Assets Amount Rs
Sundry Creditors 40,000 Inventories 40,00,000
Bills Payable 30,000 Sundry Debtors 1,40,000
Dividend Payable 36,000 Cash at Bank 40,000
Accrued Expenses 14,000 Bills receivables 60,000
Short Term 50,000 Prepaid Expenses 20,000
Advances Machinery 2,00,000
Share Capital 1,50,000 Land & Building 1,50,000
Debentures 2,00,000
Compute Inventory Turnover Ratio
Particulars Amount Rs
Sales 1,00,00,000
Direct Material 40,00,000
Direct labour 10,00,000
Factory Overheads 5,50,000
Office expenses 2,00,000
Depreciation 1,00,000
Marketing Expense 2,00,000
.......................................................... ………………………………………………………
.
32,00,000
Inventory as on 31.03.2020
Short term solvency position -ACTIVITY RATIOS
• Inventory Turnover ratio = 47,50,000/ (32,00,000+40,00,000)/2
• = 1.319 times
• Average inventory turnover Days = Number of days in a
year/Inventory turnover Ratio
• = 365/1.319
• = 276.71 days
• Working Capital Turnover Ratio is another important turnover ratio that helps the business to
determine the utilization efficiency of the working capital of a business. This ratio explains the
relationship between Sales / COGS and working capital.
• Formula
• Working Capital Turnover Ratio = Sales or Cost of Goods Sold / Working Capital
• Where
• COGS = SALES- GROSS PROFIT
OR
• DIRECT EXPENSES + OPENING STOCK – CLOSING STOCK
• &
• Working Capital = Current Assets - Current Liabilities
• Generally, higher Working Capital Turnover ratio means that a business working capital is efficiently
utilized. On the contrary, the lower ratio shows that a business is having too many debtors or there
is a lot of inventory lying that is not an efficient use of resources.
• X Ltd., has a current ratio of 3.5 : 1 and Liquid ratio of 2 : 1.
• If excess of current assets over Liquid assets represented by
inventories is Rs. 24,000,
• calculate current assets and current liabilities.
• Current Ratio = 3.5 : 1 Liquid Ratio = 2 : 1
Let Current liabilities = x
Current assets = 3.5x and
Liquid assets = 2x
Inventories = Current assets − Liquid assets
24,000 = 3.5x − 2x
24,000 = 1.5x
Current Liabilities = Rs. 16,000
Current Assets = 3.5x = 3.5 × Rs. 16,000 = Rs. 56,000.
• Verification:
• Current Ratio = Current assets : Current liabilities
= Rs. 56,000 : Rs. 16,000
= 3.5: 1
Quick Ratio = Quick assets : Current liabilities
= Rs. 32,000 : Rs. 16,000 = 2 : 1
Current Assets Company A Company B
Cash Balance 3,40,000 6,00,000
Sundry Debtors 5,48,000 8,48,000
Inventories 18,00,000 27,00,000
Total Current Assets 26,88,000 41,48,000
Current liabilities 10,00,000 12,80,000
Current Ratio Inventory turnover ratio
Company A = 26,88,000 / 10,00,000 = 2.69 :1 Company A = 33,60,000/18,00,000 = 1.87 : 1
Company B = 41,48,000/12,80,000 = 3.24 : 1 Company B = 20,40,000/ 27,00,000 = 0.75 : 1
Liquid ratio Inventory holding period
Company A = 8,88,000/ 10,00,000 = 0.89 : 1 Company A = 365/1.87 = 195 days
Company B = 14,48,000 /12,80,000 = 1.13 :1 Company B = 365/0.75 = 487 days
Current Assets Company A Company B
Cash Balance 3,40,000 6,00,000
Sundry Debtors 5,48,000 8,48,000
Inventories 18,00,000 27,00,000
Total Current Assets 26,88,000 41,48,000
Current liabilities 10,00,000 12,80,000
Quick Ratio
Company A = 3,40,000/ 10,00,000 = 0.34 :1
Company B = 6,00,000/12,80,000 = 0.47 : 1
Debtor turnover ratio Average Collection period
Company A = 48,00,000/ 5,48,000 = 8.75 : 1 Company A = 365/8.75 = 42 days
Company B = 34,00,000 /8,48,000 = 4.0:1 Company B = 365/4 = 91.25 days
• From the following particulars extracted from the books of Ashok & Co. Ltd., compute the following
• ratios and comment:
• (a) Current ratio, (b) Acid Test Ratio, (c) Stock-Turnover Ratio, (d) Debtors Turnover Ratio, (e)
• Creditors' Turnover Ratio, and Average Debt Collection period.
• 1-1-2002 31-12-2002
• Rs. Rs.
• Bills Receivable 30,000 60,000
• Bills Payable 60,000 30,000
• Sundry Debtors 1,20,000 1,50,000
• Sundry Creditors 75,000 1,05,000
• Stock-in-trade 96,000 1,44,000
• Additional information:
• (a) On 31-12-2002, there were assets: Building Rs. 2,00,000, Cash Rs. 1,20,000 and Cash at Bank Rs.
• 96,000.
• (b) Cash purchases Rs. 1,38,000 and Purchases Returns were Rs. 18,000.
• (c) Cash sales Rs. 1,50,000 and Sales returns were Rs. 6,000.
• Rate of gross profit 25% on sales and actual gross profit was Rs. 1,50,000
Trading account
Particulars Amount Particulars Amount
To opening stock 96,000 Sales : Cash 1,50,000
Purchases : Cash 1,38,000 Credit 4,56,000
Credit : 3,78,000 Gross sales 6.06.000
Gross Purchases 5,16,000 Less returns 6000
Less returns : 18,000 4,98,000 Net Sales (150000/.25) 6,00,000
Gross profit 1,50,000 Closing Stock 1,44,000
7,44,000 Total 7,44,000
• Current Ratio : CA/CL
• CA = Stock + Debtors + Bills receivable + Cash + Bank balance
• = 1,44,000+ 1,50,000+60,000+1,20,000+96,000
• = 5,70,000
• CL = Creditors + Bills payable
• = 1,05,000 + 30,000
• = 1,35,000
• CR = 5,70,000/1,35,000 = 4.22 :1
• Acid test ratio : Current assets – Inventories/CL
• = 5,70,000 – 1,44,000 = 4,26,000
• CL = Creditors + Bills payable
• = 1,05,000 + 30,000
• = 1,35,000
• Acid Test Ratio = 4,26,000/1,35,000 = 3.16 :1
• Stock Turnover ratio : Cost of goods sold/ Average stock
• COGS = sales – Gross profit
• = 6,00,000 – 1,50,000 = 4,50,000
• Average Stock = ( 96,000 + 1,44,000 )/2 = 1,20,000
•
• = 4,50,000/1,20,000 = 3.75 times
• Debtors Turnover ratio : Credit sales/ Average Debtors
• Credit sales = 4,50,000
• Average debtors = ((debtors + BR) + (Debtors + BR))/2
• = ((1,20,000+30,000) + (1,50,000+60,000))/2
• = 1,80,000
• = 4,50,000/1,80,000 = 2.5 times
• Average Collection period : 365/2.5 = 146 days
• Creditors Turnover ratio : Credit Purchases/ Average Creditors
• Credit Purchases = 3,78,000
• Average debtors = ((Creditors + BP + (Creditors + BP))/2
• = ((75,000+60,000) + (1,05,000+30,000))/2
• = 1,35,000
• = 3,78,000/1,35,000 = 2.8 times
• Average payment period : 365/2.8 = 130 days
Short term solvency position
• CURRENT ASSET TO FIXED ASSETS RATIO = CURRENT ASSETS/FIXED
ASSETS
• THIS RATIO HELPS FOR EXAINING THE FOLLOWING WORKING
CAPITAL POLICIES
• CONSERVATIVE POLICIES – HIGHER THE RATIO
• MODERATE POLICIES – RATIO AT AVERAGE LEVEL
• AGGRESSIVE POLCIES. – LOWER LEVEL OF RATIO
