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Liquidity Ratios
Liquidity Ratios
These ratios asses the ability of the firm to pay its short term debts.
Concerned with working capital of the business.
If there is too little working capital then business could become illiquid and fail to settle short
term debts.
On the other hand, if there is too much money tied up in working capital, then this could be
used more effectively and profitability by investing in other assets.
Current Ratio
This compares the current assets with the current liability of the business .
Current ratio= current assets
Current liabilities
Result can either be expressed as ratio (2:1) or just a number (2)
The recommended result is 1.5-2, but much depends on the industry the firm operates in and
recent trend in the current ratio.
A result of 1:1 means $1 of worth of asset is present to pay for $1 liability and it is risky. Very
low current ratio might not be usual for businesses that have regular inflows of cash such as
cash sales, that they rely on to pay short term debts.
Current ratio over 2 might mean money is tied up in unprofitable inventories, debtors and cash
and thus have better usage.
A low current ratio might lend to corrective management action to improve cash position.
Sale of redundant assets, cancelling capital spending plans, share issue or taking long term
loans.