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## Liquidity Ratios: The Case For/Against Bank Overdrafts

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 a company’s liquidity. Here short-term 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 Households/Current Debtors

Quick Rate, or Test-Test Rate, such as:

Quick Rate = [Current Assets – Inventories – Prepaid Expenses]/[Current Liabilities – Bank Overdraft]

Basically, these ratios are related to assets and liabilities that arise during daily activities. By definition, the quick ratio includes assets that are readily realizable, and current liabilities with short maturity periods.

Opinions remain divided on whether bank surpluses should be included in liquidity ratio calculations. A surplus is usually a short-term arrangement to cover temporary shortfalls in cash resources. Interest is charged only on amounts drawn against the permitted limit. Such interest usually occurs at very short intervals and is often variable. Since the borrowing company has to devote its resources to the regular monitoring of the interest rate, and to renegotiate the terms of the loan, the excesses are drawn only when necessary. In addition, the overdraft facility can be canceled at any time. These factors reveal the fundamental short-term nature of this form of finance. Therefore, most analysts prefer to include it as part of current liabilities and current ratio. However, some take a different view.

Bank overdrafts are drawn against lines of credit that typically extend for more than a year and are usually renewed at maturity. However, most organizations maintain such facilities to use when needed. More or less, these tools become a permanent source of funding. As a common practice, bank overdrafts are not called on demand, and add a permanent margin. This explains why, as a convention, they are excluded from the Quick Rate calculation.

The final decision, inclusion or exclusion, will depend on the specifics of the case at hand, for example, if a credit institution is created in a short period of time without the intention of renewing the organization, it may be wise. to include the overpayment in the accounts. Thus, if an excess is called upon demand, it is definitely part of the Current Rate, and depending on the details, it may form part of the Quick Rate.

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