Liquidity Ratios: The Case For/Against Bank Overdrafts

Liquidity ratios are used to measure an entity’s ability to fulfill its financial obligations in the short-term, i.e. they are measures of a firm’s liquidity. Short-term here 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 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]

Fundamentally, these ratios relate to the assets and liabilities that come up in the course of the day-to-day activities. By definition, quick ratio takes into account the most readily realizable assets, and temporary liabilities with short maturity periods.

The opinions, on whether or not the bank overdrafts should be included in the calculations of the liquidity ratios, remain 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.