Short Term Solvency Ratio

Solvency measures a company's ability to meet its financial obligations.

Liquidity means the capability of being converted into cash with ease. Liquidity ratios help to assess the ability of a business concern to meet its short term financial obligations. Short term assets (current assets) are more liquid as compared to long term assets (fixed assets). Liquidity ratios are also called as short term solvency ratios.


Liquidity ratios include: (i) Current ratio and (ii) Quick ratio.

(i) Current ratio
The current ratio gives the proportion of current assets to current liabilities of a business concern. It is computed by dividing current assets by current liabilities. The current ratio indicates the ability of an entity to meet its current liabilities as and when they are due for payment. It is calculated as follows:
Current ratio = Current assets / Current liabilities

Higher the current ratio, the better is the liquidity position, as the firm will be in a better position to pay its current liabilities. However, a much higher ratio may indicate inefficient investment policies of the management.

(ii) Quick ratio
The quick ratio gives the proportion of quick assets to current liabilities. It indicates whether the business concern is in a position to pay its current liabilities as and when they become due, out of its quick assets. Quick assets are current assets excluding inventories and prepaid expenses.

It is otherwise called liquid ratio or acid test ratio. It is calculated as follows:

Quick ratio = Quick assets / Current liabilities
Quick assets = Current assets – Inventories – Prepaid expenses
Higher the quick ratio, better is the short-term financial position of an enterprise.

Normally, 2:1 is considered as an ideal current ratio; 1:1 is considered an ideal quick ratio. However, it is subject to change from business to business and industry to industry.