Liquidity Ratios (Cambridge (CIE) IGCSE Accounting)
Revision Note
Written by: Dan Finlay
Reviewed by: Lucy Kirkham
What are liquidity ratios?
Liquidity ratios are ways to measure how quickly a business can convert assets into cash
They compare the current assets to the current liabilities
The liquidity ratios are:
Current ratio
Liquid (acid test) ratio
Current Ratio
What is the current ratio?
The current ratio is also known as the working capital ratio
Working capital is current assets minus current liabilities
What is the formula? | |
---|---|
How should the value be written? | Write as a ratio (X : 1) |
How should the value be rounded? | Round to two decimal places |
What does the value mean? | The value represents the amount of current assets available to cover each $1 of current liability |
How can the ratio be increased? |
|
A ratio close to 2:1 is generally good
If it is less than 1:1 then the business does not have enough current assets to cover its current liabilities
If it is too high then the business could have too much inventory or trade receivables
They need to improve their inventory control
They need to encourage credit customers to pay faster
Worked Example
Elena and Tom are in a partnership. They provide the following information at 31 March 2024.
$ | |
Trade receivables | 34 000 |
Trade payables | 28 000 |
Inventory | 20 000 |
Bank | 5 000 |
Other payables | 4 000 |
Calculate the current ratio. Your answer should be correct to two decimal places.
Answer
Calculate the total current assets
Trade receivables + Inventory + Bank
$34 000 + $20 000 + $5 000 = $59 000
Calculate the total current liabilities
Trade payables + Other payables
$28 000 + $4 000 = $32 000
Calculate the current ratio
Round to two decimal places and write as a ratio
Current ratio = 1.84 : 1
Liquid (Acid Test) Ratio
What is the liquid (acid test) ratio?
The liquid ratio is also known as the acid test or the quick ratio
It measures how well current liabilities are covered by the more liquid forms of current assets—cash and trade receivables
What is the formula? | |
---|---|
How should the value be written? | Write as a ratio (X : 1) |
How should the value be rounded? | Round to two decimal places |
What does the value mean? | The value represents the amount of cash and receivables available to cover each $1 of current liability |
How can the ratio be increased? |
|
A ratio close to 1:1 is generally good
If it is above 1:1 then the business has enough liquid assets to cover its short-term debts even if the inventory cannot be sold
If it is too high then the business could be owed too much by trade receivables
They need to encourage credit customers to pay faster
Examiner Tips and Tricks
You can either subtract the inventory from the total current assets or add up all the current assets excluding the inventory.
Worked Example
Elena and Tom are in a partnership. They provide the following information at 31 March 2024.
$ | |
Trade receivables | 34 000 |
Trade payables | 28 000 |
Inventory | 20 000 |
Bank | 5 000 |
Other payables | 4 000 |
Calculate the liquid (acid test) ratio. Your answer should be correct to two decimal places.
Answer
Calculate the total current assets excluding the inventory
Trade receivables + Bank
$34 000 + $5 000 = $39 000
Calculate the total current liabilities
Trade payables + Other payables
$28 000 + $4 000 = $32 000
Calculate the current ratio
Round to two decimal places and write as a ratio
Current ratio = 1.22 : 1
Evaluating Liquidity
How do I evaluate the liquidity of a business?
The liquid ratio is the best indicator of the liquidity of a business
However, it is helpful to look at both ratios together
The difference between the two ratios tells you about the proportion of the current assets that are made up of inventory
The current ratio might be good but the liquid ratio might be too low
This suggests the business has a lot of money tied up in inventory
The ratios might be very similar
This suggests the business does not have a lot of inventory
This means they might not have sufficient supplies to meet demand
If both ratios are too low then:
The business might not be able to repay short-term debts on time
The business might not have the resources to pay credit suppliers quickly and therefore miss out on cash discounts
The owner(s) might not be able to take drawings
Pay attention to whether the goods are purchased and sold on credit or cash
If goods are purchased using cash then there will be no trade payables
If goods are sold for cash then there will be no trade receivables
This might not affect the current assets as the bank increases instead of the trade receivables
How do I compare the liquidity of a business between years?
Compare the ratios to the same ratios from previous years
For each ratio
Make a general comment
State whether it has improved or gotten worse
State the ratios
Give possible reasons for the change
Possible reasons for a decrease in the ratios
Less cash or a higher bank overdraft due to
Purchase of a non-current asset
Increase in drawings
Repayment of long-term loans
Decrease in other current assets
Trade receivables
Increase in current liabilities
Trade payables
Short-term loans
Possible reasons for an increase in the ratios
More cash or a lower bank overdraft due to
Sale of a non-current asset
Decrease in drawings
New long-term loans
Increase in other current assets
Trade receivables
Decrease in current liabilities
Trade payables
Short-term loans
Worked Example
Tala is a sole trader and her financial year ends 31 March. She provides the following information.
At 31 March 2023 | At 31 March 2024 | |
Current ratio | 1.56 : 1 | 0.94 : 1 |
Liquid (acid test) ratio | 1.03 : 1 | 0.79 : 1 |
(a) Suggest two reasons for the change in the ratios.
(b) Suggest two reasons why Tala should aim to increase the ratios.
Answer
(a) State two reasons why both ratios could have decreased. As both have decreased then this suggests there has not been a decrease in the inventory.
The current ratio has worsened by decreasing from 1.56 : 1 to 0.94 : 1 and the liquid ratio has also worsened by decreasing from 1.03 : 1 to 0.79 : 1.
One possible reason is that Tala might have purchased a non-current asset for cash which would decrease the current assets. Alternatively, she might have used a short-term loan to purchase the non-current asset, which would have increased the current liabilities
Another possible reason is that Tala might have increased the amount of drawings in the form of cash. This would decrease the money in the bank.
(b) State two reasons why it is better to have higher ratios.
One reason why Tala should increase her ratios is so that she is able to repay her short-term debts without incurring late charges or interest.
Another reason to increase the ratios is so that Tala has enough funds to pay for the business expenses without requiring further short-term loans.
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