Liquid (acid test) ratio
Liquid (Acid Test) Ratio 📊
What is it? The liquid ratio tells you how well a company can cover its short‑term debts using the most liquid assets (cash, marketable securities, and receivables). Think of it as a fuel gauge for a business: it shows whether you have enough fuel (liquid assets) to keep the car (company) running without dipping into the gas tank (inventory).
Formula 💡
$$ \text{Liquid Ratio} = \frac{\text{Cash + Marketable Securities + Trade Receivables}}{\text{Trade Payables}} $$
Interpretation 🔍
- Ratio ≥ 1 – The company can pay all its short‑term debts using only the most liquid assets.
- Ratio < 1 – The company would need to sell inventory or borrow to cover its payables.
- Higher ratios indicate stronger liquidity but may also suggest that the company is not investing cash efficiently.
Example Calculation 🧮
Let’s calculate the liquid ratio for ABC Ltd.
- Gather the figures from the balance sheet:
- Cash: $12,000
- Marketable Securities: $8,000
- Trade Receivables: $15,000
- Trade Payables: $20,000
- Insert into the formula:
- Numerator: $12,000 + $8,000 + $15,000 = $35,000
- Denominator: $20,000
- Compute:
- $\frac{35,000}{20,000} = 1.75$
- Interpret:
- 1.75 > 1 → Good liquidity. ABC Ltd can cover its payables with liquid assets alone.
| Item | Amount ($) |
|---|---|
| Cash | 12,000 |
| Marketable Securities | 8,000 |
| Trade Receivables | 15,000 |
| Trade Payables | 20,000 |
| Liquid Ratio | 1.75 |
Exam Tips 🎯
1. Identify the numerator and denominator – Remember: Cash + Securities + Receivables over Payables.
2. Watch for “trade” prefixes – Only trade receivables and payables are used; other receivables (e.g., interest) are excluded.
3. Interpret the result – A ratio < 1 is a red flag; ≥ 1 is generally acceptable. Use the context of the industry if the question asks.
4. Check units – All figures should be in the same currency; if not, convert first.
Good luck and keep your ratios balanced! 🚀
Revision
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