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NISM-Series-XV: Research Analyst · Company Analysis - Financial Analysis

Liquidity, Leverage and Solvency Ratios Explained

Updated 11 October 2026 · Fact-checked

Liquidity ratios, such as the current ratio and quick ratio, test whether a company can pay bills due within a year. Leverage and solvency ratios, such as debt-equity and interest coverage, test long-term financial strength. To solve a question, pick the right formula, sort the items correctly, compute, then interpret.

Understand Liquidity, Leverage and Solvency Ratios

Every company must pay its bills. Some bills fall due soon, like supplier dues and short-term loans. Others are long-term, like bonds and term loans. Ratios help you judge both.

Liquidity ratios measure the ability to meet short-term obligations, usually those due within 12 months. The current ratio compares current assets with current liabilities. The quick ratio (acid-test ratio) does the same but removes inventory, because inventory can take time to sell and may sell below book value.

Leverage ratios show how much of the business is funded by borrowed money. The debt-equity ratio compares debt with shareholders' equity. A higher ratio means more reliance on lenders and more risk if profits fall.

Solvency is the ability to meet long-term obligations and stay in business. Debt-equity is often used as a solvency measure. Interest coverage is another: it shows how many times operating profit covers interest cost. A low value means a small profit fall can leave the company unable to pay interest.

No ratio is good or bad on its own. Compare it with the company's past values and with peers in the same industry. Banks and NBFCs carry high debt by nature, so their norms differ from those of manufacturers.

Key formulas to remember

Current ratio
Current ratio = Current assets ÷ Current liabilities
A value above 1 means current assets exceed current liabilities. The ideal level depends on the industry.
Quick ratio
Quick ratio = (Current assets − Inventory) ÷ Current liabilities
Some texts also exclude prepaid expenses. Follow the data the question gives. Always remove inventory.
Debt-equity ratio
Debt-equity ratio = Total debt ÷ Shareholders' equity
Check whether the question uses total debt or only long-term debt. Use the definition stated.
Interest coverage ratio
Interest coverage = EBIT ÷ Interest expense
EBIT is earnings before interest and tax. Also called times interest earned.
Debt ratio
Debt ratio = Total debt ÷ Total assets
Shows the share of assets financed by debt.

How to solve Liquidity, Leverage and Solvency Ratios questions

Use this method for any numerical or conceptual question on these ratios.

  1. 1Identify the type: liquidity (short-term) or leverage and solvency (long-term).
  2. 2Write the formula before you touch the numbers.
  3. 3Sort balance sheet items. Current assets and current liabilities are due or realised within a year.
  4. 4For the quick ratio, subtract inventory from current assets first.
  5. 5For interest coverage, use EBIT, not profit after tax, unless the question says otherwise.
  6. 6Compute and keep two decimal places.
  7. 7Interpret: higher liquidity and coverage are safer, higher debt-equity is riskier.
  8. 8Check the options for traps, such as an answer that used the wrong numerator.

Quickest way: Sort, subtract, divide

When to use it: Use it for numerical MCQs when time is short.

  1. Circle the ratio asked and recall its formula.
  2. Pick only the numbers the formula needs. Ignore the rest.
  3. Subtract inventory at once for a quick ratio.
  4. Divide and match to the option.
  5. Cross-check: quick ratio must be lower than or equal to the current ratio.

Common mistakes in Liquidity, Leverage and Solvency Ratios

  • Leaving inventory in the quick ratio.

    Students mix up the current and quick ratio formulas.

    Fix: Remember quick means fast cash. Inventory is not fast, so remove it.

  • Using net profit instead of EBIT in interest coverage.

    Net profit is the number most often quoted.

    Fix: Interest is paid before tax and out of operating profit, so use EBIT.

  • Calling a higher debt-equity ratio always bad.

    Students want one fixed rule.

    Fix: Higher means more risk, but acceptable levels vary by industry. Compare with peers.

  • Confusing liquidity with solvency.

    Both sound like financial safety.

    Fix: Liquidity is short-term bill-paying. Solvency is long-term survival.

  • Treating a current ratio far above the norm as purely good.

    Higher feels safer.

    Fix: A very high value can mean idle cash or slow-moving inventory and receivables.

Worked examples

Example 1

A company has EBIT of ₹90 lakh, interest expense of ₹15 lakh, total debt of ₹120 lakh and shareholders' equity of ₹200 lakh. Find interest coverage and debt-equity ratio.

Show the solution
  1. Interest coverage = EBIT ÷ Interest = 90 ÷ 15 = 6 times.
  2. Debt-equity = Total debt ÷ Equity = 120 ÷ 200 = 0.60.

Answer: Interest coverage is 6 times and debt-equity ratio is 0.60.

Example 2

A company has current assets of ₹8,00,000, of which inventory is ₹3,00,000. Current liabilities are ₹4,00,000. Find the current ratio and quick ratio.

Show the solution
  1. Current ratio = 8,00,000 ÷ 4,00,000 = 2.00.
  2. Quick assets = 8,00,000 − 3,00,000 = ₹5,00,000.
  3. Quick ratio = 5,00,000 ÷ 4,00,000 = 1.25.

Answer: Current ratio is 2.00 and quick ratio is 1.25.

Exam tips

  • Expect formula-based questions, so learn each numerator and denominator exactly.
  • Watch for options built from the wrong formula, such as a current ratio offered as the quick ratio answer.
  • Conceptual questions often ask which ratio tests short-term versus long-term strength.
  • Negative marking applies, so skip only if you cannot narrow to two options.
  • In caselets, compute the ratio once and reuse it for later questions.

Practice questions from Company Analysis - Financial Analysis

Liquidity, Leverage 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.

Liquidity, Leverage and Solvency Ratios: frequently asked questions

What is the difference between current ratio and quick ratio?

The current ratio uses all current assets. The quick ratio removes inventory, so it is a stricter test of short-term liquidity. The quick ratio is never higher than the current ratio.

What is the difference between liquidity and solvency ratios?

Liquidity ratios show whether a company can pay obligations due within a year. Solvency ratios show whether it can meet long-term obligations and survive over time.

What does a low interest coverage ratio mean?

It means operating profit barely covers interest cost. The company is at higher risk of default if earnings fall.

Is a high debt-equity ratio always bad?

No. It signals higher financial risk, but normal levels differ by industry. Compare with peers and the company's own history.