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Current Ratio: This ratio deals with the relationship between current assets and liabilities. It is calculated as:
Current assets are those assets which can be easily converted into cash whereas Current liabilities are liabilities that need to paid within that accounting period
Importance of Current Ratio
Current ratio helps in determining a firm’s ability to pay off the current liabilities on time. If there is more of current assets as compared to current liabilities, it provides a source of security to the creditors. The ideal ratio is 2:1 (Current Assets: Current Liabilities)
2. Liquid Ratio– It deals with the relationship between liquid assets and current liabilities. This ratio determines if the firm has sufficient funds for paying off the current liabilities on an immediate basis. It can be calculated as:
Importance of Liquid Ratio
It is helpful in determining if a firm has funds that can be sufficient to pay off liabilities. It does not include stock or prepaid expenses as both these are not easily converted to cash. A ratio of 1:1 is ideal for maintaining the liquid ratio.
Current ratio is best suited for businesses where the available stock or inventories cannot be converted to cash easily. Examples of such industries can be locomotive companies, heavy machinery manufacturing companies etc. as heavy machinery, tools which cannot be sold easily. Similarly, businesses that can easily convert or get sold off prefer the liquid ratio as a measure to determine their liquidity. A service company is more likely to use liquid ratio as no stock is maintained.
There will be some instances when companies tend to change the ratio method being used and chose accordingly. If a company is not maintaining any stock or inventory, liquid ratio is the best option, while if stock forms the majority of the company’s assets then current ratio is the best choice as the liquid ratio of such a firm will be very low and that can create a negative impact on creditors. In such case, current ratio is a better choice to determine the overall liquidity.