Definition: Liquidity ratios give a common approximation of the solvency of a company.
Here are a list of common liquidity ratios and formulas:
1) Current ratio (also known as a working capital ratio)
= Current Assets / Current Liabilities
2) Fast ratio, in times (also known as the acid test ratio or Fast assets ratio)
= (Current Assets – Stock) / Current Liabilities
6) Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
3) Interest Coverage = Profit previous to Tax / Interest Charge
4) Gearing ratio = Long Term Liabilities / Equity Shareholders’ Funds
5) Cash Ratio = Cash / Current Liabilities
Example:
Calculate the operational capital, gearing ratios and acid test and given the following figures:
Debtors: $20,000
Creditors: $6,000
Bank: $11,000
Cash: $1,000
Closing stock: $6,000
Opening stock: $7,000
Total Capital and Reserves: $25,000
Long term loan: $15,000
Solution:
Working capital ratio = 20,000 / 6,000 = 3.33 (This means that current assets are 3.33 times current liabilities)
Current asset = debtors + bank + cash + closing stock = 20000 + 11000 + 1000 + 6000 = $38,000
Equity Shareholders’ Funds = Total Capital and Reserves + Long term Liabilities = 25000 + 15000 = $40,000
Gearing ratio = 15,000 / 40,000 = 0.375
Acid test ratio = (20,000 – 6,000) / 6,000 = 2.33 (This means that current assets in liquid form are 2.33 times current liabilities)