What are liquidity ratios?
Ratios derived from the balance sheet that measure how easily a firm can pay its
debts
Two key ratios
• There are two key ratios that can be calculated to provide a guide to the
liquidity position of a business:
• The current ratio (or current acid ratio)
current assets /current liabilities
• The acid test or quick ratio
current assets less stock /current liabilities
Interpreting the current and acid test ratios (general)
• A business needs to have enough cash or cash to come to be able to pay its
debts
• A current ratio in excess of one should be expected (although firms in some
industries manage with less)
• An acid test ratio of around one is also desirable
• It will mean that the firm will have little difficulty in meeting its debts
Liquidity
• The liquidity position of a business refers to its ability to pay its debts
• Liquid assets are those that are held in cash form or can be turned in cash very
quickly
• The question to consider is - does the firm have enough cash or sufficient
access to cash to pay the bills?
• The liquidity ratios are of particular interest to lenders and potential lenders
Liquidity Ratios
• These indicate the ability of a business to pay its creditors (i.e. its debts when
they fall due)
• They enable us to examine the strength or weakness of the firm in terms of its
ability to meet its short term debts
• They measure the ability of the firm to survive and avoid default
• For this reason they are known as the as solvency ratios
The Two Ratios
 Are concerned with the ability of the business to pay its debts
• Are the ratio of short term liabilities to liquid assets
• Indicate the ability of the business to cover its short term liabilities
• Can be expressed as ratio (1:2), a factor (2) or a percentage (200%)
Current Ratio
• This ratios is a test of liquidity which determines whether short term assets
cover short term liabilities
• Calculation: current assets divided by current liabilities
• Or stock + debtors + cash divided by current liabilities
• It shows how many times current liabilities are covered by current assets
• A figure of one means that CA exactly equal CL.
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A figure of 1.5 means that CA assets cover CL one and a half times over
Interpretation of Current Ratio
• The textbook ideal is somewhere between 1.5 and 2 but this is only a guide
• If it is lower, it means there is a danger of insufficient cash to pay off debts as
they fall due - especially if a high proportion of current assets consists of
stocks
• If it is higher, it suggests that too much money is tied up in stock or left idle as
cash or debtors
Acid Test (or Quick) Ratio
• This is a measure of extreme short term liquidity
• It is similar to the current ratio but it excludes stock
• This makes it a tougher test of liquidity
• Calculation:
– current assets less stock divided by current liabilities OR
– cash plus debtors divided by current liabilities
Why exclude stock?
• Stock takes longer to turn into cash
• Stock is the least liquid of current assets
• The firm will be reluctant to sell off stock in a rush - to do so will mean
reducing price and therefore reducing profits
• The acid test is a measure of whether the business can meet its short-term
debts without selling off any stock
Interpreting the acid test ratio
• The ideal is said to be 1 to 1.5. Again this is only a guide
• A ratio of 1 means that current assets less stock exactly cover current
liabilities
• If it is lower there is danger of insufficient cash to debts as they fall due
• If it is higher it suggests the firm has too much cash or debtors
But is all relative
• Some businesses find it hard to turn stock and debtors into cash and so need a
high ratio
• Some businesses such as supermarkets turn stock into cash very rapidly - so
they can happily exist with a current ratio of less than one and even as low as
0.3
• Large firms are powerful enough to delay payment to suppliers and therefore
can happily operate with low liquidity ratios
• The acid test is a better test of liquidity for businesses with a low stock
turnover
Limitations of liquidity ratios
• Like all ratios they should be used with care
• The liquidity ratios are derived from the balance sheet which in turn is a
snapshot at a moment in time. Balance sheet values at a particular moment in
time may not be typical
• Ratios can be subject to window dressing or manipulation
• Ratios concern the past and not the future
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Ratios do not tells what is going right or wrong-they merely invite further
questions
Liquidity ratios will vary with seasonal fluctuations in sales
What is satisfactory will depend on the nature of the business, the nature of the
products and the time of year
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