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Short Term Solvency (Liquidity) Ratios (Definition)

As the name suggests short term solvency ratios or commonly known as liquidity ratios are used to obtain

information about the company’s ability to meet its short term obligations as and when fall due. In other words ability to settle obligations that fall due within a period of 12 months, therefore these ratios focus on current assets and liabilities of the company.

Types of Short Term Solvency (Liquidity) Ratios

To check the ability of the company of meeting its short term obligations following ratios are used.

  • Current Ratio
  • Quick Ratio or Acid Test Ratio
  • Cash Ratio

Use this brain map after studying all five ratios to understand the logic.
Following pages will explain the listed above ratios using the written below method:

FORMULA (short term solvency ratios)

First question comes in mind is HOW TO CALCULATE THE PARTICULAR RATIO? I will write down the most common formula used for calculating a ratio along with alternative, if any.

 

EXAMPLE (short term solvency ratios)

With example I will calculate the ratio using the formula given above. PLEASE NOTE THAT, in examples I will use data from HYPOTHETICAL FINANCIAL STATEMENTS (as given here)so that you can calculate ratios from real financial statements in you practical life.

 

MEASUREMENT UNIT (short term solvency ratios)

In which unit the ratio is measured i.e. in currency unit (dollars), percentages, days or whatever.

INTERPRETATION (short term solvency ratios)

After calculating the ratio, the next logical question that comes in mind is WHAT DOES THIS RATIO MEAN? So I will teach

  • How to interpret the ratio; and
  • What particular user needs this ratio addresses. (You must have an understanding of users’ needs of financial statements; please refer the topic 1- financial statement users for details).
  • INTERPRETATION ALONG WITH OTHER RATIOS
    A ratio gives useful information however when interpreted along with other ratios, the meaning and usefulness of ration increases manifolds. Therefore I will teach you what a ratio means when interpreted with the combination of several other ratios.

    HOW TO IMPROVE RATIO? (short term solvency ratios)

Although improving the ratio is concern of management as compared to external users but I find it appropriate to include it here as management is responsible for taking care of several users (i.e. both at input and output level).

 

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