Liquidity Ratios (DP IB Business Management)

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

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
  

  

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