Liquidity Ratios (DP IB Business Management)

Revision Note

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

fraction numerator Current space assets over denominator Current space liabilities end fraction space space

equals space ? space colon 1

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

    fraction numerator space Current space assets space minus space stock over denominator Current space liabilities end fraction

equals space space space space space ? space space space space space space colon space space space space space 1

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

Reduce the credit period offered to customers

  • Collecting money owed from customers more quickly will increase the level of current assets in the business

  • Customers may move to competing businesses that offer better credit terms

Ask suppliers for an extended repayment period e.g an extension from 60 to 90 days

  • Current liabilities will not be reduced

  • The business can use cash it would have paid to suppliers for other purposes

  • Suppliers may be unwilling to extend credit terms

Make use of Overdraft facilities or short-term loans

  • Current liabilities will increase

  • The business can spend more money than it has in its bank account

  • Banks may be reluctant to lend to businesses with cash-flow problems

Sell off excess stock

  • Less liquid current assets will be reduced and converted into more liquid forms of current asset (e.g. cash)

  • Storage and security costs may also be reduced

  • Stock may need to be sold at a low price to attract sales

Sell assets and lease fixed assets instead (e.g. sale and leaseback)

  • Both current assets and current liabilities will increase

  • The business will continue to have the use of assets but must make regular payments to the leasing company

Introduce new capital and reduce drawings out of the business

  • Current assets will be increased

  • New capital may be introduced by the owner or from additional investors

    • This may result in a dilution of control over the business

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