In this session we shall look at what is meant by the term liquidity and why it is important to any business. We shall then consider two different liquidity ratios, the Current Ratio and the Acid Test Ratio.
Liquidity
Liquidity refers to the ability of a business to access cash quickly. A company’s assets are regarded as being liquid if they are in the form of cash or if they could be converted into cash in a short period. Assets are illiquid if they will take time to convert into cash.
A company with low liquidity is at risk of running out of cash and as a result might be unable to pay its employees, suppliers or lenders on time. This can damage the company’s relationships with these important stakeholders and in serious cases can lead to the failure of the business.
It is therefore vital for any business to have good liquidity.
A related term is solvency. A solvent company is one where the risk of it going out of business is low. An insolvent company is one that is unable to pay its debts. A company with poor liquidity is at a higher risk of becoming insolvent.
Liquidity Ratios
Liquidity ratios look at a company’s short-term financial strength and by doing so, measures the risk that the business might run out of cash and be unable to pay its debts.
Unlike the ratios we have already covered, liquidity ratios are presented as ratios (i.e. 3 to 1, or 3:1). Take care to show the ratios to the number of decimal places specified but if this is not provided, one or two decimal places will usually provide sufficient accuracy.
The Current Ratio
The current ratio puts the value of a business’ current assets in terms of its current liabilities. The idea behind this ratio is that a company with plenty of current assets compared to its current liabilities should have little trouble in paying its liabilities as they fall due.
The formula for the current ratio is
Quick questions
1. A business’ has current assets of £598,911 and current liabilities of £215,669. Calculate its current ratio to two decimal places
Click here to reveal the answer
Current ratio is 2.78:1
2 A business has a current ratio of 2.56:1, if its current assets are £744,000 calculate its current liabilities
Click here to reveal the answer
Current liabilities are 744,000/2.54 = £290,625
3. A business has a current ratio of 3.1:1, if its current liabilities total £154,380 calculate the value of its current assets
Click here to reveal the answer
Current assets are 154,380 x 3.1 = £478,578
Illustration
A company’s financial statements are shown below.
The current ratio is calculated using the total of Current Assets and Current Liabilities as taken from the Statement of Financial Position.
Current Ratio: 2,780/1,490 = 1.87 : 1
Evaluating Current Ratios
Generally, a higher current ratio is better than a lower current ratio. So if a company’s current ratio had changed from 2.1:1 to 2.4:1 we would say that the ratio had improved.
Some accountants say that a current ratio of less than 2:1 is a potential problem but this is just a rule-of-thumb and is not be applicable to many types of business.
Similarly, some accountants say that a high current ratio (for instance 4:1) might indicate that the business is managing its working capital inefficiently. It might indicate that the company has more current assets than it should:
- It might be carrying too much inventory; or
- It might have poor credit control leading to customers paying late
- It might have too much cash in its bank account (remember that investors expect a return on their money but cash held in a current bank account will earn little or no interest)
Current ratio: reasons for change
A company’s current ratio might be different from its comparator because it has different policies regarding the management of its current assets and/or current liabilities; e.g.
The Quick Ratio or Acid Test Ratio
The Quick Ratio (also known as the Acid Test Ratio) is a more extreme version of the Current Ratio. It seeks to compare a company’s most liquid assets (i.e. assets that are in the form of cash, or will be converted into cash within a short-period) against its current liabilities. For many businesses, inventories can take a long time to convert into cash and as a result the Quick Ratio omits the value of inventories from the calculation of a company’s liquidity.
The Quick Ratio is calculated using the following formula.
Quick questions
1. A business’ current assets consist of the following: inventory of £26,482, trade receivables of £34,716 and bank balances of £5,119. It also has current liabilities consisting of trade payables of £18,640, tax of £6,357 and lease liabilities of £726.
Calculate the quick ratio to one decimal place
Click here to reveal the answer
Quick ratio is (26,482+34,716+5,119-26,482)/(18,640+6,357+726) = 1.5:1
2. A business’ current assets consist of trade receivables of £27,400 and its inventory. Its acid test ratio is 0.89:1 If the business has current liabilities of £41,900 calculate the value of its inventory
Click here to reveal the answer
Total of current assets is 41900 x 0.89 = £37,291
Value of inventory is 37,291 – 27,400 = £9,891
Illustration
A company’s financial statements are shown below.
The quick ratio will be calculated using information taken from the Statement of Financial Position. We shall use the total of Current Assets, the value of Inventories and the total of Current Liabilities.
Quick Ratio: (2,780 – 1,190)/1,490 = 1.07: 1
Evaluating Quick Ratios
Generally, a higher current ratio is better than a lower ratio. As was the case with the Current Ratio, many accountants use a rule-of-thumb that says a Quick Ratio of less than 1:1 indicates that the business has a liquidity problem.
Quick ratio: reasons for change
A company’s quick ratio might be different from its comparator for a variety of reasons including those below.
Question 1
A company’s statement of profit or loss and statement of financial position are shown below.
a) Calculate, to two decimal places, the current ratio for both years and state whether the ratio has improved or worsened from 2019 to 2020
Click here to reveal the answer
Current ratio
- Y/E 31/12/2020: 144,668/70,751 = 2.04 : 1
- Y/E 31/12/2019: 124,995/75,597 = 1.65 : 1
- The current ratio has improved
b) Calculate, to two decimal places, the quick or acid test ratio for both years and state whether the ratio has improved or worsened from 2019 to 2020
Quick ratio or Acid Test ratio
- Y/E 31/12/2020: (144,668-55,989)/70,751 = 1.25 : 1
- Y/E 31/12/2019: (124,995-50,064)/75,597 = 0.99 : 1
- The quick ratio has improved
Question 2
A company’s statement of profit or loss and statement of financial position are shown below
Question
Calculate the current ratio and quick ratio to two decimal places for both years and state whether they are better or worse in 2020 than they were in 2019
Click here to reveal the answer
- Y/E 31/12/2020: Current ratio is 367,031/70,333 = 5.22:1
- Y/E 31/12/2019: Current ratio is 326,466/63,654 = 5.12:1
- The current ratio is slightly better in 2020 than in 2019
- Y/E 31/12/2020: Quick ratio is (367,031-125,481)/70,333 = 3.43:1
- Y/E 31/12/2019: Quick ratio is (326,466-102,360)/63,654 = 3.52:1
- The quick ratio is slightly worse in 2020 than in 2019
