The current ratio provides a better measure of overall liquidity only when a firm’s inventory cannot easily be converted into cash.

The above mentioned statement is true. There are two different ways to measure the liquidity of a firm first through current ratio of the firm and second through quick ratio of the firm. The second one is considered the more refine form of measuring the liquidity of the firm. The current ratio ‘explains the relationship between current assets and current liabilities. If current assets are quite capable to pay the current liability the liquidity of the concerned firm will be considered good. But here generally one question arises there are certain assets which cannot be converted into cash quickly such as stock and prepaid expenses. As far as the matter of prepaid expenses is concerned it’s ok but what about the stock if we measure the liquidity on the basis of conversion of current assets in cash there are many firms where conversion of stock is not possible into cash frequently say e.g., heavy machinery manufacturing companies, locomotive companies, etc. This is because, the heavy stocks like machinery, heavy tools etc. cannot be easily sold off. In this case it is always advisable to follow the current ratio for measuring the liquidity of a firm.

But on the other hand, in case of those firms where the stock can be easily realised or sold off consideration of stock should be avoided and to measure the liquidity of that firm Quick ratio should be calculated, e.g., the inventories of a service sector company are very liquid as there are no stocks kept for sale, so in that case liquid ratio must be followed for measuring the liquidity of the firm. 

We can understand from the above mentioned statement in the light of another example where stock contribute the major portion in current assets in that case to find out the liquidity of that firm stock cannot be avoided to measure the liquidity of the firm. On the other hand where stock contributes a reasonably less amount it can be avoided and liquidity of that firm can be measured with the help of quick ratio. On the other hand where there is a lot of fluctuation in the price of stock it is always advisable to compute quick ratio and avoid the stock figure because it will reduce the authenticity of liquidity measure.

Current Ratio: It explains the relationship between current assets and current liabilities. It is calculated as:

Current Ratio = \(\frac {\textit{Current Assets}}{\textit{Current Liabilities}} \)

Currents Assets are those assets that are easily converted into cash within a short period of time like cash in hand, cash at bank, marketable securities, debtors, stock, bills receivables, prepaid expenses, etc.

Current Liabilities are those liabilities that are to be repaid within a year like bank overdraft, bills payables, Short-term creditors, provision for tax, outstanding expenses etc:

Liquid Ratio: It explains the relationship between liquid assets and current liabilities. It indicates whether a firm has sufficient funds to pay its current liabilities immediately. It is calculated as:

Liquid Ratio = \(\frac {\textit{Liquid Assets}}{\textit{Current Liabilities}} \)

Liquid Assets = Current Assets – Stock – Prepaid Expenses

Generally, Current Ratio is preferable for such type of business where the stock or the inventories cannot easily be converted into cash like heavy machinery manufacturing companies, locomotive companies, etc. This is because, the heavy stocks like machinery, Heavy tools etc. cannot be easily sold off. But on the other hand, the businesses where the stock can be easily realised or sold off regard Liquid Ratio to be more suitable measure to reveal their liquidity position. For example, the inventories of a service sector company are very liquid as there is no stock kept for sale, so they prefer Liquid Ratio as a measure of overall liquidity.

Moreover, sometimes companies prefer to resort to Liquid Ratio instead of Current Ratio, if the prices of the stock held are prone to fluctuate. This is because if the prices of the inventories fluctuate more, then this may affect their liquidity position of the business and may reduce (or overcast) the Current Ratio. Consequently, they prefer Liquid Ratio as it excludes inventories and stocks.

Thirdly, if the stock forms the major portion of a company’s current assets, then they would prefer Current Ratio and not Liquid Ratio. This is because their current assets mostly consist of stock. The Liquid Ratio of such company will be very low as liquid assets exclude stock. This will reduce their Liquid Ratio and may create a bad image’for the creditors. In such a case, Current Ratio provides better measure of overall-liquidity.