A type of liquidity ratio used to evaluate a company’s short-term solvency or financial standing is the absolute liquidity ratio. Absolute liquid assets are calculated by deducting receivables from current and liquid assets.
Despite the fact that receivables, debtors, and bills receivables are typically more liquid than inventories, there could be questions regarding how quickly or immediately they can be converted into cash due to the likelihood of bad debts.
To exclude out this possibility, absolute ratio is found. The absolute liquid ratio is also known as the cash ratio. The absolute liquid ratio is calculated as follows:
Absolute liquid ratio = current liabilities minus absolute liquid assets
Liquidity Ratio: Its Importance
A useful financial metric for assessing a company’s financial position is the liquidity ratio. A method for assessing a company’s cash position is the liquidity ratio. It assists in figuring out the immediate financial condition.
A higher percentage shows that the business is stable. On the other hand, a low ratio raises the possibility of financial loss. This ratio offers a complete picture of the business’s internal structure. It demonstrates how successfully and fast a business sells its goods and services in order to turn inventories into cash.
Using this ratio, a business can optimise its production process, plan better inventory storage to cut losses, and plan efficient overhead costs.
• A corporation’s management has a role in determining its financial stability. A company can increase its management effectiveness in responding to the demands of potential creditors by using this ratio.
• By using this ratio, management can try to reduce the amount of working capital needed by the organisation.
Limitations of Liquid Ratio
• Just like the quantity of liquid assets, quality matters. This ratio only takes a company’s current assets into account. In addition to using liquidity measures, several accounting standards should be employed to evaluate a company’s liquidity strength.
• The liquidity ratio utilises inventory to determine a company’s liquidity. On the other side, overestimating could result in a computation error. Less sales may result from having more inventory. The underlying liquidity of a corporation may therefore not be accurately reflected by inventory calculations.
• This ratio might be the consequence of inventive accounting since it only uses balance sheet data. To completely understand an organization’s financial position, analysts must dig beyond the balance sheet data and conduct a liquidity ratio research.
Frequently Asked Questions about Liquidity Ratio
How do you tell the difference between liquidity and solvency?
The cash on hand to cover a business’s immediate financial obligations is referred to as liquidity. On the other side, the ability of a company to pay off its total debt while still being operational is referred to as “solvency.” A company’s account solvency is significantly influenced by the liquidity ratio.
What current-to-voltage ratio is ideal?
If the current ratio is larger than 1, that is considered ideal. A company’s superior liquidity position is demonstrated by a greater current ratio.
What exactly does SLR mean?
Government securities, including as bonds, cash, and gold, are regarded as assets to maintain SLR, or Statutory Liquidity Ratio, in accordance with RBI requirements.
What asset has the greatest liquidity?
Cash is the world’s most liquid asset. If a corporation has more cash on hand, its liquidity ratio will be higher. This suggests that without the aid of outside finances, the questioned company is able to meet any short-term financial promise.