### Liquidity Ratio Analysis & Example

Definition: Liquidity ratios provide a general estimate of solvency of a company.

List of common liquidity ratios and formulas:

1) Current ratio (also known as working capital ratio)

= Current Assets / Current Liabilities

2) Quick ratio, in times (also known as acid test ratio or quick assets ratio)

= (Current Assets - Stock) / Current Liabilities

3) Interest Coverage = Profit Before Tax / Interest Charge

4) Gearing ratio = Long Term Liabilities / Equity Shareholders' Funds

5) Cash Ratio = Cash / Current Liabilities

6) Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities

Example:

Calculate the working capital, acid test and gearing ratios, given the following figures:

Debtors: $2,000

Creditors: $5,000

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:

Current assets = debtors + bank + cash + closing stock = 2000 + 11000 + 1000 + 6000 = $20,000

Working capital ratio = 20,000 / 5,000 = 4 (This means that current assets are 4 times current liabilities)

Acid test ratio = (20,000 - 6,000) / 5,000 = 2.8 (This means that current assets in liquid form are 2.8 times current liabilities)

Equity Shareholders' Funds = Total Capital and Reserves + Long term Liabilities = 25000 + 15000 = $40,000

Gearing ratio = 15,000 / 40,000 = 0.375

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List of common liquidity ratios and formulas:

1) Current ratio (also known as working capital ratio)

= Current Assets / Current Liabilities

2) Quick ratio, in times (also known as acid test ratio or quick assets ratio)

= (Current Assets - Stock) / Current Liabilities

3) Interest Coverage = Profit Before Tax / Interest Charge

4) Gearing ratio = Long Term Liabilities / Equity Shareholders' Funds

5) Cash Ratio = Cash / Current Liabilities

6) Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities

Example:

Calculate the working capital, acid test and gearing ratios, given the following figures:

Debtors: $2,000

Creditors: $5,000

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:

Current assets = debtors + bank + cash + closing stock = 2000 + 11000 + 1000 + 6000 = $20,000

Working capital ratio = 20,000 / 5,000 = 4 (This means that current assets are 4 times current liabilities)

Acid test ratio = (20,000 - 6,000) / 5,000 = 2.8 (This means that current assets in liquid form are 2.8 times current liabilities)

Equity Shareholders' Funds = Total Capital and Reserves + Long term Liabilities = 25000 + 15000 = $40,000

Gearing ratio = 15,000 / 40,000 = 0.375

* Featured Articles:

Operating Cash Flow to Sales Ratio

Profitability Ratio Analysis and Example

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