Difference Between the Three Liquidity Ratios
Liquidity ratios relate to short-term assets and liabilities that come up during the regular operations. The period of 12 months pertains to the Current Ratio. The Quick Ratio, however, includes only the most liquid assets and temporary liabilities with maturity periods of 90 days or less. Super-Quick ratio has the narrowest definition.
Understanding the Bank Overdraft
Banks extend an overdraft limit or overdraft protection to businesses with a good track record. If a business does not have enough balance in its account to make payments, the bank makes up for the shortfall. Bank Overdrafts come with a ceiling on maximum withdrawals. The interest is charged only on the amounts drawn. Such interest often accrues at very short intervals and is usually variable.
Another very similar instrument is a line of credit or a revolving credit. Both facilities work like credit cards, where you can continue to borrow and repay within the allotted limits. Interest charge applies only to the amount of actual drawing. Borrowings against a line of credit are more like short-term loans. Overdrafts, on the other hand, are allowed only when the bank account runs out of money. Both involve maintenance charges, but interest rates on overdrafts are higher.
Characteristics of Bank Overdrafts and Credit Lines
Businesses use bank overdrafts only cases of emergency. It is not a good sign if a company has to use them regularly. Certain types of businesses can be in greater need of short-term loans against credit lines than others. Consider the case of a firm which is diversifying its operations and there is uncertainty around the likely market response. Raising a fixed-term loan will not be a suitable option in this case. A credit line, however, will act as a backup to even out any unusual and unpredictable movements.
Despite the associated benefits, these borrowings are much more expensive than other forms of credit and therefore, used sparingly. In addition, both of these facilities can be canceled at any time.
Inclusion or Exclusion From the Ratios Analysis
There are no standard terms of agreement when it comes to the interest rates or repayment schedules of these sources of funding. Overdrafts or borrowings can fall due anywhere from 1 month to 6 months or other period, as agreed. This largely depends upon the creditworthiness of the borrower. These credits are not usually not callable on demand.
Both the items must form a part of the Current Ratio. The repayment period will affect whether or not they will be included in Quick and Super-Quick Ratios. This implies that the final decision will depend upon the specifics of the case at hand. For instance, if an overdraft is callable on demand, you must include it in all the three ratios.