calculate and interpret the following liquidity ratios: – current ratio – acid test ratio

5.5.2 Liquidity – Understanding How Quickly a Business Can Pay Its Bills

What is Liquidity?

Liquidity is a company’s ability to turn its assets into cash quickly to meet short‑term obligations. Think of it like having a spare change in your wallet – you can use it right away when you need it.

Key Liquidity Ratios

  • Current Ratio – measures how many times a company’s current assets cover its current liabilities.
  • Acid Test Ratio (Quick Ratio) – similar to the current ratio but excludes inventory, which may not be sold quickly.

Formula Box

Current Ratio: Current Assets ÷ Current Liabilities

Acid Test Ratio: (Current Assets – Inventory) ÷ Current Liabilities

Example Calculation

Let’s look at a fictional company, BrightTech Ltd.:

Item £ (thousands)
Cash & Cash Equivalents 120
Accounts Receivable 80
Inventory 50
Total Current Assets 250
Accounts Payable 100
Short‑Term Loans 30
Total Current Liabilities 130

Now calculate the ratios:

  1. Current Ratio: 250 ÷ 130 ≈ 1.92
  2. Acid Test Ratio: (250 – 50) ÷ 130 ≈ 1.54

Interpretation

💡 Current Ratio 1.92 – BrightTech has £1.92 in current assets for every £1 of current liabilities. A ratio above 1 indicates the company can cover its short‑term debts.

💡 Acid Test Ratio 1.54 – Even after removing inventory, the company still has £1.54 in quick assets per £1 of liabilities. This shows stronger liquidity because inventory may take time to sell.

🔍 What to look for in exams: A ratio < 1 means the company may struggle to pay its bills on time. Ratios that are too high (e.g., >3) could suggest the company isn’t using its assets efficiently.

Exam Tips Box

📌 Remember:

  • Use the correct formula – don’t forget to subtract inventory for the acid test ratio.
  • Show all steps in your calculation – examiners will mark for clarity.
  • Interpret the result – explain what the ratio tells you about the company’s financial health.
  • Compare with industry averages if given – this shows deeper analysis.

Quick Practice Question

BrightTech Ltd. has current assets of £300k and inventory of £90k. Its current liabilities are £150k. Calculate the current ratio and acid test ratio, and state whether the company is likely to be able to meet its short‑term obligations.

🧮 Answer:

  1. Current Ratio: 300 ÷ 150 = 2.0
  2. Acid Test Ratio: (300 – 90) ÷ 150 = 1.4
  3. Interpretation: Both ratios > 1, so BrightTech is likely to meet its short‑term obligations.

Remember the Analogy

Think of liquidity like a rainbow of cash: the current ratio is the whole spectrum, while the acid test ratio is the brightest part that you can use instantly. A healthy rainbow means you’re ready for any financial storm! 🌈

Revision

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