Ratio Analysis: Liquidity Ratios Explained — Current Ratio, Quick Ratio & Cash Ratio (With Solved Examples)

Introduction

Ratio Analysis is the chapter in Class 12 Accountancy (and CA Foundation Accounts) where students most often lose marks — not because the calculations are complex, but because they confuse which items go in the numerator and which in the denominator, and because they cannot interpret a ratio once they've calculated it.

This article focuses on Liquidity Ratios — the group of ratios that measure a firm's ability to meet its short-term obligations — covering all three ratios in depth: Current Ratio, Quick Ratio (Acid-Test Ratio), and Cash Ratio.

What Is Ratio Analysis?

Ratio analysis is a technique of analysing financial statements (Balance Sheet and Profit & Loss Account) by expressing the relationship between two related financial figures as a ratio, fraction, or percentage.

The purpose is to evaluate a firm's liquidity, profitability, solvency, and efficiency — in a way that raw numbers alone don't reveal.

Major Categories of Ratios

This article covers only Liquidity Ratios — the most commonly tested in one-mark and three-mark questions in CBSE Class 12 papers.

Ratio 1: Current Ratio

The Current Ratio measures whether a firm has enough current assets to cover its current liabilities. It is the most basic liquidity test.

What Are Current Assets?

Current assets are assets expected to be converted into cash or used up within one accounting year (12 months).

• Cash and Cash Equivalents (cash in hand, cash at bank)
• Short-Term Investments (marketable securities)
• Trade Receivables (Debtors + Bills Receivable) — after deducting Provision for Doubtful Debts
• Inventories (Stock — Raw Material, WIP, Finished Goods)
• Prepaid Expenses
• Advance Tax paid / Tax Refund Receivable
• Short-Term Loans and Advances receivable within a year

What Are Current Liabilities?

Current liabilities are obligations expected to be settled within one accounting year.

• Trade Payables (Creditors + Bills Payable)
• Short-Term Borrowings (bank overdraft, cash credit, short-term loans)
• Outstanding Expenses (accrued liabilities)
• Income Received in Advance (unearned income)
• Proposed Dividend (if shown as a current liability)
• Provision for Tax (current year's tax liability)

Ideal Value & Interpretation

Solved Example — Current Ratio

Ratio 2: Quick Ratio (Acid-Test Ratio)

The Quick Ratio is a stricter test of liquidity than the Current Ratio. It excludes items that cannot be quickly converted to cash — primarily Inventories and Prepaid Expenses — because in an emergency, a firm cannot liquidate these instantly at full value.

Ideal Value & Interpretation

Solved Example — Quick Ratio

Ratio 3: Cash Ratio (Absolute Liquidity Ratio)

The Cash Ratio is the most conservative liquidity measure — it considers only cash, bank balances, and short-term marketable investments as truly liquid, excluding even trade receivables.

Ideal Value

A Cash Ratio of 0.5:1 is generally considered adequate. A ratio of 1:1 means the firm holds sufficient cash to pay all current liabilities immediately — but this is rarely desirable since it implies excess idle cash not being productively deployed.

Solved Example — Cash Ratio

All Three Ratios — Side-by-Side Summary

Common Exam Mistakes in Liquidity Ratios

• Including Loose Tools, Stores & Spares in Quick Assets: These are effectively inventory and must be excluded from Quick Assets even if they appear under a separate heading.
• Treating Bank Overdraft as not a Current Liability: Bank overdraft is always a Current Liability.
• Forgetting to deduct Provision for Doubtful Debts from Trade Receivables: Always use net Trade Receivables in both Current Ratio and Quick Ratio.
• Including Advance Tax Paid under "Loans & Advances" as not a Current Asset: If paid during the year and refund is expected within 12 months, it is a Current Asset.
• Confusing the ideal values: 2:1 for Current Ratio and 1:1 for Quick Ratio.

FAQs

Q1. If a firm's Current Ratio is 3:1, is it in a strong financial position?

Not necessarily. While a 3:1 ratio shows the firm can easily meet short-term dues, it may also indicate that too much capital is locked up in current assets such as excess inventory, slow-collecting debtors, or idle cash. Ideal is closer to 2:1.

Q2. Why is Prepaid Expense excluded from Quick Assets?

Because a prepaid expense, such as prepaid insurance, has already been paid — it cannot be converted back to cash. It represents a future benefit, not a liquid asset.

Q3. Is goodwill included in Current Assets?

No. Goodwill is an intangible fixed asset — it is not current and is never included in Current Assets for ratio analysis purposes.

Q4. Can the Quick Ratio be higher than the Current Ratio?

No. Quick Assets are always a subset of Current Assets because items are removed from Current Assets to calculate Quick Assets. Therefore:

Conclusion

Liquidity ratios — Current, Quick, and Cash — are the foundation of financial statement analysis in Class 12 and CA Foundation. The three formulas are straightforward once you're clear on which components go where.

In every board question involving these ratios, write down the formula first, identify components from the Balance Sheet carefully, especially inventory and prepaid items, calculate, and then add a one-line interpretation stating whether the ratio is below, at, or above the ideal.

Article prepared for SRC Classes Online · Content aligned with CBSE Class 12 Accountancy (Part I, Chapter: Analysis of Financial Statements) and CA Foundation Principles & Practice of Accounting.