Liquidity Ratios (Cambridge (CIE) O Level Accounting)

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

• 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

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

• 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

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