Liquidity ratios are used to measure an entity’s ability to meet its financial obligations in the short term, i.e. they are measures of the company’s willingness to pay. Short-term here means a maximum period of 12 months. The two most important liquidity ratios are Current Ratio and Quick Ratio. The formula for the current ratio is:
Current ratio = current assets/current liabilities
The Quick Ratio or Acid-Test Ratio is presented as follows:
Quick ratio = [Current Assets – Inventories – Prepaid Expenses]/[Current Liabilities – Bank Overdraft]
Basically, these ratios relate to assets and liabilities that arise during day-to-day operations. By definition, the quick ratio takes into account the assets that can be most easily realized and short-term liabilities with a short maturity.
Opinions are divided on whether overdrafts should be included in liquidity ratio calculations. An overdraft is usually a short-term loan arrangement to cover temporary cash shortages. Interest is charged only on amounts withdrawn against the permitted limit. Such interest is often accumulated in very short intervals and is usually variable. Since the borrowing company must allocate resources to regular monitoring of the interest rate and renegotiation of the loan terms, overdrafts are raised sparingly, only when necessary. In addition, the overdraft can be canceled at any time. These factors highlight the essential short-term nature of this form of financing. Therefore, most analysts prefer to include it as part of current liabilities and current ratio. However, some disagree.
Overdrafts are usually drawn against lines of credit of more than a year and are often renewed when they are due. In addition, most organizations keep such facilities available when needed. These instruments become a more or less permanent source of funding. As a general practice, overdrafts cannot be reclaimed, which further increases permanence. This explains why they are usually left out of the quick ratio calculation.
The final decision to include or exclude depends on the specifics of the case in question, for example if a line of credit expires in the short term with no intention of the organization to renew it, it may make sense. takes account overdraft into account in calculations. Similarly, if an overdraft is redeemable on demand, it is definitely part of the Current Ratio, and depending on other details, it may well be part of the Quick Ratio.