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Liquidity ratios are used to measure the ability of an entity to meet its financial obligations in the short term, that is, they are measures of the liquidity of a company. In this case, short term refers to a period of 12 months or less. Two of the most important liquidity ratios are the current index and the fast index. 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 ratio = [Current Assets – Inventories – Prepaid Expenses]/[Current Liabilities – Bank Overdraft]

Basically, these ratios refer 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 maturity periods.

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Opinions on whether or not to include bank overdrafts in the calculation of liquidity ratios remain divided. An overdraft is usually a short-term loan arrangement to cover any temporary shortfall in cash resources. Interest is charged only on amounts withdrawn against the allowed limit. This interest often increases at very short intervals and is often variable. As the borrowing company has to allocate its resources for regular interest rate monitoring and renegotiation of loan terms, overdrafts are withdrawn sparingly, only when necessary. Also, the overdraft line can be canceled at any time. These factors highlight the short-term essentiality of this mode of financing. Therefore, most analysts prefer to include it as part of current liabilities and current ratio. However, some have a different opinion.

Bank overdrafts are drawn against lines of credit that generally extend for periods beyond one year and are often rolled over at maturity. Additionally, most organizations maintain these facilities for use when needed. More or less, these instruments become a permanent source of financing. As a common practice, bank overdrafts are not enforceable on demand, which adds a greater degree of permanence. This explains why, as a convention, they are excluded from the Quick Ratio calculation.

The final decision, to include or exclude, will depend on the details of the case in question, for example, if a line of credit should expire in the short term without the intention of the organization to renew it, it may be prudent. to include the overdraft in the calculations. Similarly, if an overdraft is enforceable on demand, it is definitely part of the current index and, subject to other details, it may well be part of the quick index.

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