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Ratio Analysis: Liquidity and Solvency Ratios for CA Final FR

Updated 5 October 2026 · Fact-checked

Liquidity ratios test whether a business can pay its dues within the next 12 months. Solvency ratios test whether it can carry its debt and interest over the long term. Compute current ratio, quick ratio, debt-equity, interest coverage and DSCR from the statements, then interpret each in the case's context.

Understand Ratio Analysis: Liquidity and Solvency Ratios

Liquidity is the ability to meet short-term obligations as they fall due. A lender or supplier asks: if I am owed money in the next year, will the business have cash to pay me? The current ratio and quick ratio answer this by comparing current assets with current liabilities.

Solvency is the ability to survive and meet obligations over the long term. Here the question is how much of the business is funded by borrowing, and whether profits and cash flows can service that borrowing. Debt-equity, interest coverage and debt service coverage answer this.

The current ratio counts all current assets. The quick ratio is stricter. It leaves out inventories (and prepaid expenses), because they cannot be turned into cash quickly or at certain value. So a business with a healthy current ratio but a weak quick ratio is leaning on stock to pay its bills.

Solvency ratios come in two types. Balance-sheet ratios, like debt-equity, show the capital structure at a date. Coverage ratios, like interest coverage and DSCR, link the profit and loss account or cash flow to the burden of debt. Use the first to see how much risk is built into funding, and the second to see whether earnings can bear it.

A ratio alone proves nothing. Compare it with the earlier year, with the industry, and with the business model. A retailer with fast-moving stock can run safely on a current ratio below 1. A manufacturer with slow receivables may be in trouble even at 1.5. Always classify items as the Balance Sheet does under Schedule III (Division II): current versus non-current.

Key rules to remember

Current ratio: Current ratio = Current assets ÷ Current liabilities; Expressed as a number, e.g. 1.5 : 1. The old 2 : 1 benchmark is only a rule of thumb, not a rule. Judge against the industry.
Quick (acid-test) ratio: Quick ratio = Quick assets ÷ Current liabilities, where Quick assets = Current assets − Inventories − Prepaid expenses; Some texts exclude only inventories. Follow the definition given in the question. If none is given, state your definition.
Absolute cash ratio: Cash ratio = (Cash and bank balances + Marketable current investments) ÷ Current liabilities; The strictest liquidity test. Shows ability to pay at once from cash-like items.
Debt-equity ratio: Debt-equity = Total debt ÷ Shareholders' equity; Debt usually means long-term and short-term borrowings. Equity is share capital plus other equity. A wider version uses total outside liabilities. State the definition you use.
Debt to total capital: Debt ÷ (Debt + Equity) × 100; Shows the share of capital that is borrowed.
Proprietary ratio: Proprietary ratio = Shareholders' equity ÷ Total assets; Higher means more owner funding and a greater safety cushion for creditors.
Interest coverage ratio: Interest coverage = EBIT ÷ Finance costs; EBIT = Profit before tax + Finance costs. Result is in 'times'. A low value means little margin before interest cannot be met.
Debt service coverage ratio (DSCR): DSCR = Earnings available for debt service ÷ (Interest + Principal repayment due in the year); Earnings available = Profit after tax + Depreciation + Other non-cash charges + Finance costs. Use the components the question specifies.

How to solve Ratio Analysis: Liquidity and Solvency Ratios questions

Use this order for any liquidity or solvency question. It keeps your working clean and earns interpretation marks.

1Read what is asked: which ratios, and for which years. Note any definition the question gives for quick assets, debt or earnings.
2List current assets and current liabilities from the Balance Sheet. Follow the current and non-current classification.
3Compute liquidity ratios: current, quick and, if asked, cash ratio. Show the numerator and denominator separately.
4Compute solvency ratios: debt-equity first, then EBIT, then interest coverage, then earnings available and DSCR.
5Write the formula before each calculation. Round to two decimals and give units (times, ratio or %).
6Interpret each ratio in one or two sentences: is it adequate, rising or falling, and why it matters to the lender or investor.
7Close with a conclusion that links liquidity and solvency together, and mention one limitation, such as year-end window dressing or industry differences.

Quickest way: Table-first shortcut

When to use it: When the question gives many figures and time is short, especially in the 70% descriptive section.

Make a two-line table: current assets split into inventories, prepaid and the rest, and current liabilities as one total.
Get quick assets by subtracting inventories and prepaid from current assets. Do not re-add anything.
Get EBIT by adding finance cost to PBT. Never start from PAT.
For DSCR, add PAT, depreciation and finance cost in one line, then divide by interest plus principal.
Write a one-line verdict per ratio, such as 'quick ratio below 1, depends on stock'.

Common mistakes in Ratio Analysis: Liquidity and Solvency Ratios

Including inventories and prepaid expenses in quick assets.
Students copy the current ratio numerator and forget the stricter test.
Fix: Always start from current assets and subtract inventories and prepaid expenses (or as the question defines). Then check that quick ratio is not higher than current ratio.
Using PBT or PAT instead of EBIT in interest coverage.
PBT is already after interest, so it looks like the profit figure to use.
Fix: Add finance costs back to PBT to reach EBIT. Then divide by finance costs.
Leaving principal repayment out of DSCR.
DSCR is confused with interest coverage.
Fix: The denominator is interest plus the principal due in the year. Add depreciation and other non-cash charges to the numerator.
Defining debt inconsistently in debt-equity, such as excluding short-term borrowings in one year and including them in another.
Students pick only the long-term borrowings line without reading the question.
Fix: State your definition of debt and apply it to every year. Include current maturities and short-term borrowings unless told otherwise.
Stating the ratio without interpretation, or saying '2 : 1 is ideal' for every business.
Rote learning of a textbook benchmark.
Fix: Say what the number means for this business, compare with another year or the industry, and mention the business model.
Misreading the effect of a transaction on the ratios, for example thinking that paying creditors from cash always improves the current ratio.
Students do not recompute with the changed numerator and denominator.
Fix: Recompute both sides. If the current ratio is above 1, paying a current liability from cash raises it. If it is below 1, the same payment lowers it. The same logic applies to the quick ratio: payment from cash raises it if it is above 1 and lowers it if it is below 1. In the worked example the quick ratio is 0.80, which is below 1, so it falls.

Worked examples

Example 1

A company's Balance Sheet shows: inventories ₹40,00,000; trade receivables ₹30,00,000; cash and bank balances ₹10,00,000; current investments (readily marketable) ₹8,00,000; prepaid expenses ₹2,00,000. Current liabilities: trade payables ₹30,00,000; short-term borrowings ₹20,00,000; provisions ₹10,00,000. (a) Compute current ratio, quick ratio and cash ratio. (b) Recompute the current and quick ratios if the company pays ₹10,00,000 of trade payables out of its bank balance. Comment.

Show the solution

Current assets = 40,00,000 + 30,00,000 + 10,00,000 + 8,00,000 + 2,00,000 = ₹90,00,000.
Current liabilities = 30,00,000 + 20,00,000 + 10,00,000 = ₹60,00,000.
Current ratio = 90,00,000 ÷ 60,00,000 = 1.50.
Quick assets = 90,00,000 − 40,00,000 − 2,00,000 = ₹48,00,000. Quick ratio = 48,00,000 ÷ 60,00,000 = 0.80.
Cash ratio = (10,00,000 + 8,00,000) ÷ 60,00,000 = 18,00,000 ÷ 60,00,000 = 0.30.
After payment: current assets = 90,00,000 − 10,00,000 = ₹80,00,000. Current liabilities = 60,00,000 − 10,00,000 = ₹50,00,000.
New current ratio = 80,00,000 ÷ 50,00,000 = 1.60.
New quick assets = 48,00,000 − 10,00,000 = ₹38,00,000. New quick ratio = 38,00,000 ÷ 50,00,000 = 0.76.
Comment: the current ratio is adequate at 1.50, but the quick ratio is below 1 and the cash ratio is low. The company relies on selling inventory and collecting receivables to meet dues. Paying creditors raised the current ratio but lowered the quick ratio because cash, a quick asset, was used up.

Answer: Current ratio 1.50, quick ratio 0.80, cash ratio 0.30. After the payment: current ratio 1.60, quick ratio 0.76. Liquidity depends on inventory and receivables.

Example 2

For the year, a company reports: equity share capital ₹50,00,000; other equity ₹70,00,000; long-term borrowings ₹80,00,000; short-term borrowings ₹20,00,000; profit before tax ₹36,00,000 after finance costs of ₹12,00,000; tax at 30% of PBT; depreciation ₹14,80,000; principal repayment due during the year ₹18,00,000. Compute debt-equity, debt to total capital, interest coverage and DSCR. Comment.

Show the solution

Equity = 50,00,000 + 70,00,000 = ₹1,20,00,000.
Total debt = 80,00,000 + 20,00,000 = ₹1,00,00,000.
Debt-equity = 1,00,00,000 ÷ 1,20,00,000 = 0.83.
Debt to total capital = 1,00,00,000 ÷ (1,00,00,000 + 1,20,00,000) × 100 = 1,00,00,000 ÷ 2,20,00,000 × 100 = 45.45%.
EBIT = PBT + finance costs = 36,00,000 + 12,00,000 = ₹48,00,000.
Interest coverage = 48,00,000 ÷ 12,00,000 = 4.00 times.
Tax = 30% × 36,00,000 = ₹10,80,000. PAT = 36,00,000 − 10,80,000 = ₹25,20,000.
Earnings available for debt service = PAT + depreciation + finance costs = 25,20,000 + 14,80,000 + 12,00,000 = ₹52,00,000.
Debt service = interest + principal = 12,00,000 + 18,00,000 = ₹30,00,000.
DSCR = 52,00,000 ÷ 30,00,000 = 1.73.
Comment: debt is less than equity, and EBIT covers interest 4 times. DSCR of 1.73 means cash earnings cover interest and repayment with a margin of about 73%. Solvency looks comfortable, but check whether the repayment schedule rises in later years.

Answer: Debt-equity 0.83; debt to total capital 45.45%; interest coverage 4.00 times; DSCR 1.73. Solvency is comfortable.

Exam tips

Write the formula and your definition of quick assets or debt before calculating. Marks are given for method even if one figure is off.
In case-scenario MCQs, read which items are inventories, prepaid or non-current before picking the numerator. Options are often built from the common errors.
In descriptive answers, give a full interpretation: level, trend, reason and recommendation. A bare number scores little.
Expect a link with other topics: classification of current and non-current items, and finance cost from the Statement of Profit and Loss. Check that your figures follow Schedule III (Division II) headings.
Keep working in rupees consistently and show two decimals so that small rounding differences do not cost the final answer.

Practice questions from Analysis of Financial Statements

Ratio Analysis: Liquidity and Solvency Ratios in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Ratio Analysis: Liquidity and Solvency Ratios: frequently asked questions

What is the difference between current ratio and quick ratio?

The current ratio divides all current assets by current liabilities. The quick ratio removes inventories and prepaid expenses from current assets first. So it tests whether you can pay dues without selling stock.

How do I calculate interest coverage ratio?

Divide EBIT by finance costs. EBIT is profit before tax plus finance costs. The answer in times shows how many times operating profit covers the interest burden.

How is DSCR different from interest coverage?

Interest coverage looks only at interest and uses EBIT. DSCR covers interest plus principal repayment and uses cash-type earnings: PAT plus depreciation and other non-cash charges plus finance costs. DSCR is the tougher test of repayment ability.

Is a current ratio of 2 : 1 always required?

No. It is only a rule of thumb. The right level depends on the industry, the speed of inventory and receivable turnover, and the credit terms the business gets. Always compare with past years and similar firms.

Which ratios fall under solvency in CA Final FR?

Debt-equity, debt to total capital, proprietary ratio, interest coverage and DSCR are the usual ones. Questions may ask you to calculate them and then comment on the capital structure and debt-servicing ability.