Liquidity Ratios (DP IB Business Management)
Revision Note
Written by: Lisa Eades
Reviewed by: Steve Vorster
Ways to Measure Liquidity
Liquidity refers to the cash and other current assets businesses have available to quickly pay bills and meet short-term business/financial obligations
The liquidity of a business can be measured using two ratios, the current ratio and the acid test ratio
1. The current ratio
The Current Ratio is a quick way to measure liquidity and the outcome is expressed as a ratio
All of the current asset are included in calculating this ratio
The current ratio is an effective liquidity measure for businesses that hold little stock
The result indicates how many £s of current assets it has available to cover each £1 of short term debt
It is calculated using the formula
Worked Example
Packer Sports Ltd has current assets of £15,545, current liabilities of £5,060 and an inventory figure of £8,250.
Calculate Packer Sports Ltd’s current ratio. [2]
Answer:
Step 1: Substitute the values into the equation
£15,545 ÷ £5,060 = 3.07 [1 mark]
Step 2: Express the outcome as a ratio
= 3.07: 1 [1 mark]
In this example, Packer Sports Ltd has £3.07 of current assets to cover each £1 of short-term debt
2. The acid test ratio
The acid test ratio is a precise way to measure liquidity and is expressed as a ratio
The acid test ratio is also known as the liquid capital ratio
The least liquid form of current assets (stock) is deducted so the acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly
It may take some time to sell stock, so it is excluded
The acid test ratio is a particularly important measure of liquidity for businesses that hold a large amount of stock
It is calculated using the formula
Worked Example
Packer Sports Ltd has current assets of £15,545, current liabilities of £5,060 and a stock figure of £8,250.
Calculate Packer Sports Ltd’s acid test ratio. [3]
Answer:
Step 1: Subtract stock from current assets
£15,545 - £8,250 = £7,295 [1 mark]
Step 1: Substitute the values into the equation
£7,295 ÷ £5,060 = 1.44 [1 mark]
Step 2: Express the outcome as a ratio
= 1.44: 1 [1 mark]
In this example, Packer Sports Ltd has £1.44 of the most liquid current assets to cover each £1 of short-term debt
Ways to improve liquidity
The best way to improve liquidity is to manage the business better
Use cash flow forecasts to identify potential cash flow issues before they arise - and take appropriate action
Budget effectively and consider adopting zero budgeting to carefully control spending
Set clear financial objectives and look for ways to reduce costs and increase income wherever possible
Methods to Improve Liquidity
Method | Explanation |
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Reduce the credit period offered to customers |
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Ask suppliers for an extended repayment period e.g an extension from 60 to 90 days |
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Make use of Overdraft facilities or short-term loans |
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Sell off excess stock |
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Sell assets and lease fixed assets instead (e.g. sale and leaseback) |
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Introduce new capital and reduce drawings out of the business |
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