Liquidity indices are used to measure an entity’s ability to meet its financial obligations in the short term, that is, they are measures of a company’s liquidity. Short term here refers to a period of 12 months or less. Two of the most important liquidity ratios are the Current Ratio and the Quick Ratio. The formula for the Current Ratio, or Working Capital Ratio, is:
Current Ratio = Current Assets/Current Liabilities
The quick ratio, or acid test ratio, is represented as:
quick relationship = [Current Assets – Inventories – Prepaid Expenses]/[Current Liabilities – Bank Overdraft]
Fundamentally, these ratios relate to assets and liabilities that arise in the course of day-to-day activities. By definition, the quick ratio takes into account the most readily realizable assets and temporary liabilities with short maturities.
Opinions remain divided on whether or not bank overdrafts should be included in the calculations of liquidity ratios. An overdraft is typically a short-term borrowing arrangement to cover any temporary shortfalls in cash resources. Interest is payable only on amounts drawn against the allowed limit. Such interest often increases at very short intervals and is usually variable. As the borrowing company has to allocate its resources for regular interest rate control and renegotiation of loan terms, overdrafts are withdrawn sparingly, only when necessary. Also, the overdraft facility can be canceled at any time. These factors highlight the essential short-term nature of this type of financing. Therefore, most analysts prefer to include it as part of current liabilities and the Current Ratio. However, some have a different view.
Bank overdrafts are drawn against lines of credit that generally extend for periods longer than one year and are often renewed at maturity. Also, most organizations maintain such facilities to be used when needed. More or less, these instruments become a permanent source of financing. As usual practice, bank overdrafts are not payable on demand, which adds a greater degree of permanence. This explains why, by convention, they are excluded from the Quick Ratio calculation.
The final decision, to include or exclude, will depend on the details of the case at hand, for example, if a line of credit is due to mature in the short term without the organization intending to renew it, it may be prudent to include the overdraft in the calculations. . Similarly, if an overdraft is due on demand, it is definitely part of the Current Ratio and, subject to other details, may well be part of the Quick Ratio.