Liquidity indices are used to measure an entity’s ability to meet its financial obligations in the short term, that is, they are measures of a company’s liquidity. In layman’s terms, this translates into cash on hand or instruments that can easily generate cash. Short term here refers to a period of 12 months or less. Two of the most important liquidity ratios are the Current Ratio and the Quick Ratio. The latter, by definition, is a more stringent measure of liquidity, as it omits any element of current assets and current liabilities with the slightest illiquidity.
Required Resources:
– Balance sheet of the company under study
– Notes to the financial statements, if required
Steps in the calculation:
1. Consider total current assets on the balance sheet. Depending on the discloser on the accounts front, you may need to look in the notes for current asset breakouts.
2. restricted cash. From total current assets, deduct ‘restricted cash’. Such cash is not available for immediate use due to certain legal or other encumbrances.
3. inventories. Deduct ‘inventories’. Accumulated salable goods can only be liquidated with a sale. Therefore, they may not be easily performed when required.
4. Prepaid expenses. Subtract plus prepaid expenses from above. Although prepaid expenses are assets in the sense that they involve some defined future outflows already met, they cannot be converted to cash, if necessary. It is extremely rare for third parties to reimburse the advance for business expenses.
5. Get to ‘quick assets’ which typically include cash, cash equivalents (marketable securities) and accounts receivable/debtors.
6. Consider the total current liabilities and their breakdown.
7. Bank overdraft. Subtract the bank overdraft from the total current liabilities. Bank overdrafts are drawn against lines of credit that generally extend for periods longer than one year and are often renewed at maturity. More or less, these instruments become a permanent source of financing. As usual practice, bank overdrafts are not payable on demand, which adds a greater degree of permanence.
8. Get quick liabilities that typically include accounts receivable/creditors, current portion of long-term debt, income tax payable, and accrued expenses of various kinds.
9. Use the formula for the final calculation to arrive at the ratio:
Quick Ratio = Quick Assets / Quick Liabilities
