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Liquidity Ratios and Bank Overdrafts

Quick Ratio Current Ratio
There are three primary liquidity ratios – Current Ratio, Quick Ratio and Super-Quick Ratio. The purpose of these performance indicators  is to assess the health of the working capital. In other words, they measure an entity’s ability to fulfill its financial obligations in the short-term, i.e. short-term solvency. The reference period is 12 months or less.
Difference Among The Three Liquidity Ratios

Liquidity ratios relate to short-term assets and liabilities that come up during the regular operations. The period of 12 month pertains to the Current Ratio. 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.

Exclusion of Bank Overdraft

The opinions about inclusion or exclusion of bank overdrafts in the liquidity ratios, remains divided. An overdraft is usually a short-term arrangement of loans to cover any temporary shortfalls in the cash resources. The interest is chargeable only on the amounts drawn against the allowed limit. Such interest often accrues at very short intervals and is usually variable. As the borrowing firm has to allocate its resources for regular monitoring of the interest rate, and renegotiating of the borrowing terms, overdrafts are sparingly drawn, only when required. In addition, the overdraft facility can be cancelled at any time. These factors bring out the essential short-term nature of this mode of financing. Therefore, most analysts prefer to include it as a part of current liabilities and that of the Current Ratio. Nevertheless, some take a different view.

Bank overdrafts are drawn against credit lines that usually extend for periods beyond a year and are often renewed on expiry. In addition, most of the organizations keep such facilities to be used when needed. More or less, these instruments become a permanent source of financing. As a common practice, bank overdrafts are not callable on demand, adding a further degree of permanence. This explains why, as a convention, they are excluded from the calculation of the Quick Ratio.

The final decision, to include or exclude, will depend upon the specifics of the case at hand, for instance, if a credit facility is due to mature in the short-term with no intention of the organization to renew it, it may be prudent to include the overdraft in calculations. Similarly, if an overdraft is callable on demand, it is definitely a part of the Current Ratio, and subject to other details, it may well form a part of the Quick Ratio.

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