Should Deferred Income be omitted when calculating liquidity ratios, as well as some other ratios, and why?

You asked2 questions:

First question:

Yes, it should be omitted.

Second question:

Liquidity ratios show a small company ability to meet and pay its short-term debt obligations. The three main ratios are current, quick and cash. The current ratio is the least conservative ratio, in that it includes the most assets with the ability to meet short-term debt obligations. The cash ratio is the most conservative as it includes cash and marketable securities while excluding any other assets.

Current Ratio

Step1

Find the company current assets on the balance sheet. For example, Firm A has $500,000 of current assets.

Step2

Find the company current liabilities on the balance sheet. In the example, Firm A has $300,000 of current liabilities.

Step3

Divide current assets by current liabilities. In the example, $500,000 divided by $300,000 equals a current ratio of1.667.

Quick Ratio

Step1

Determine the company current assets, inventory and current liabilities on the company balance sheet. For example, Firm A has $500,000 of current assets, of which $100,000 is inventory. Firm current liabilities equals $300,000.

Step2

Subtract inventories from current assets. In the example, $500,000 minus $100,000 equals $400,000.

Step3

Divide the number calculated in Step2 by the current liabilities. In the example, $400,000 divided by $300,000 equals a quick ratio of1.333.

Cash Ratio

Step1

Determine the company cash, marketable securities and current liabilities from the balance sheet. For example, Firm A has $50,000 of cash and $100,000 in marketable securities. Firm current liabilities are $300,000.

Step2

Add cash to marketable securities. In the example, $50,000 plus $100,000 equals $150,000.

Step3

Divide the number calculated in Step2 by current liabilities. In the example, $150,000 divided by $300,000 equals a cash ratio of0.5.

Deferred income should be omitted while calculating liquidity ratios, becasue the purpose for the liquidity ratios is to analyse the cash company has in it's pocket right now to meet it's operational needs. where as u don't have the money at the moment when considering deffered income.

Hi Mr Imad,

Thanks for contacting me for the answer,

The definition of deferred income or deferred revenue is that it is advance received for the work which has to be done later, or in case of products, the products have to be delivered later. The nature of such account is liability, when we will actually perform the work or will deliver the products to the client then we will debit this liability account and credit the sales/revenue account.

The preferred treatment of deferred income in liquity rations is:

1- You can include deferred income in calculating current ratio, because in this case the cash received for such advance sales is already a part to cash balance in balance sheet, and the same deffered income liability account is also available in current liabilities, so simply we can have CA/CL. Why we think this should be there because, this ratio is telling us how much CA we have for paying upcoming CL. As the said deferred income is already there as CL and we are matching it with CA, and that cash is already a part to CA so the comparison is fine and logical.

2- This decision has also a relation to the industry we are in, in case the firm is in the industry where sales retuns are very rare like in subscription based businesses, eg, newspapers, or gym or internet subscriptions where returns are very rare, then treatment mentioned above will be fine.

But in case of a business where returns are a norm, in that case we should take a conservative approach and should exclude, deferred income cash from CA and likewise exlude deferred income liability from CL.