Liquidity Ratios: The Case

For/Against Bank
Overdrafts
Sample Article

2010
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.

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Liquidity Ratios: The Case For/Against Bank Overdrafts

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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