Types of ratios; liquidity

Ratios are grouped in two ways. Traditionally, by where the figures come from: profit and loss ratios, balance sheet ratios, and composite ratios (one figure from each). Functionally, by what they measure: liquidity, solvency, activity and profitability.

Liquidity ratios check whether the firm can pay its short-term debts.

• Current ratio = current assets ÷ current liabilities. About 2:1 is thought safe.
• Quick (liquid) ratio = quick assets ÷ current liabilities, where quick assets = current assets − inventories − prepaid expenses (and advance tax). These are assets that turn into cash quickly. About 1:1 is thought safe.

A very high current ratio is not always good: it may mean too much idle stock or cash.

Missing figures: let current liabilities = x, write each ratio in terms of x, and solve. For example, if the current ratio is 3:1, the quick ratio 1.5:1, and inventory 30,000: inventory = 3x − 1.5x = 1.5x = 30,000, so x = 20,000, and current assets = 60,000.

Effect of a transaction: when the current ratio is above 1, paying a current liability in cash raises it, and buying goods on credit lowers it (both sides change by the same amount).