The absolute liquidity ratio is a sort of liquidity ratio that is used to assess a company’s short-term solvency or financial status. It is computed by subtracting receivables from current and liquid assets and determining absolute liquid assets.
Although receivables, debtors, and bills receivables are generally more liquid than inventories, there may be concerns about their immediate or timely realization into cash due to the possibility of bad debts. The absolute ratio is determined to rule out this option. The Cash ratio is another name for the absolute liquid ratio. The formula for the absolute liquid ratio is:
Absolute Liquid Ratio= Absolute Liquid Assets/ Current Liabilities
Importance of Liquidity Ratio
The liquidity ratio is a valuable financial indicator for determining a company’s financial position. A liquidity ratio is a tool for determining a company’s cash position. It also aids in determining the short-term financial situation. A greater percentage indicates that the company is stable. A low ratio, on the other hand, carries the risk of financial loss.
This ratio gives a thorough picture of the operating system of the company in question. It shows how well and quickly the company sells its products or services in order to convert inventories into cash. A corporation can optimise its production system, plan better inventory storage to reduce losses, and plan effective overhead expenses with the use of this ratio.
- The financial stability of a corporation is also determined by its management. As a result of this ratio, a corporation can improve its management efficiency in responding to potential creditors’ demands.
- With the use of this ratio, management can endeavour to improve the company’s working capital requirements.
Liquid Ratio’s Limitations:
- Quality is important, just as it is for the number of liquid assets. Only the amount of a company’s current assets is considered in this ratio. To assess a company’s liquidity strength, various accounting criteria should be used in addition to liquidity ratios.
- To calculate a company’s liquidity, the liquidity ratio uses inventory. Overestimation, on the other hand, might lead to a miscalculation. A higher inventory level can also lead to fewer sales. As a result, inventory calculations may not accurately reflect a company’s true liquidity.
- Because it solely incorporates balance sheet data, this ratio could be the result of creative accounting. Analysts must look beyond the balance sheet data to do a liquidity ratio study to fully comprehend an organization’s financial position.
Liquidity Ratio Frequently Asked Questions
How do you distinguish between solvency and liquidity?
Liquidity refers to the funds available to meet a company’s short-term financial obligations. Solvency, on the other hand, refers to an organization’s ability to repay its overall debt while continuing to operate. The liquidity ratio is an important component of a company’s account solvency.
What is the best current-to-voltage ratio?
It is regarded as optimum if the current ratio is greater than one. A higher current ratio reflects a company’s superior liquidity position.
What is the definition of SLR?
According to RBI criteria, government securities including as bonds, cash, and gold are considered assets to maintain SLR, or Statutory Liquidity Ratio.
Which asset is the most liquid?
The most liquid asset on the planet is cash. A company’s liquidity ratio will be higher if it has more cash on hand. This indicates that the company in question is capable of meeting any short-term financial commitment without the assistance of outside funds.