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

5.5.2 Liquidity

Learning Objectives

• Define liquidity and explain why it matters for a business.
• Calculate the Current Ratio and the Acid‑Test (Quick) Ratio from balance‑sheet data.
• Interpret what each ratio tells you about a firm’s short‑term financial health.
• Identify the main limitations of the ratios and relate them to working‑capital and cash‑flow management.

1. What is Liquidity?

Liquidity is a company’s ability to meet its short‑term obligations (pay suppliers, repay bank overdrafts, etc.) as they fall due, by converting assets into cash quickly and without a material loss in value.

Why it matters (for a 14‑16‑year‑old audience):

• Prevents cash‑flow crises and the risk of insolvency.
• Influences the credit terms a bank or supplier will offer.
• Gives confidence to investors, owners and other stakeholders.
• Helps managers decide whether excess cash should be invested, used to reduce debt, or kept as a safety net.
• Liquidity is a core part of working‑capital management – the balance between current assets and current liabilities.

2. Current Ratio

2.1 Definition

Shows the proportion of current assets that are available to cover current liabilities.

2.2 Formula (with clear labels)

$$\textbf{Current Ratio} = \frac{\textbf{Current Assets}}{\textbf{Current Liabilities}}$$

2.3 What is included?

Current Assets	Current Liabilities
Cash and cash equivalents Bank balances Trade receivables Inventory Pre‑payments Short‑term investments	Trade payables Short‑term borrowings Current portion of long‑term debt Accrued expenses Tax payable

2.4 Interpretation

• Ratio > 1 – More current assets than current liabilities; generally a sign of adequate liquidity.
• Ratio = 1 – Assets just cover liabilities; the firm is on the “cash‑break‑even” point.
• Ratio < 1 – Potential liquidity problem; the firm may struggle to pay short‑term debts.
• Very high ratios (e.g., > 3) – May indicate inefficient use of resources (excess cash, inventory or receivables that could be invested for profit).

2.5 Limitations

• Inventory is included even though it may not be quickly convertible to cash.
• Ignores the timing of cash inflows and outflows – a firm could have a good ratio but still run out of cash in a particular month.
• Acceptable “benchmark” levels differ by industry (e.g., retail vs. utilities).
• Can be manipulated by short‑term borrowing or by delaying payments to suppliers.

3. Acid‑Test (Quick) Ratio

3.1 Definition

Measures the ability to meet current liabilities using only the most liquid assets – those that can be turned into cash immediately.

3.2 Quick (acid‑test) assets

Quick Assets (most liquid)
Cash and cash equivalents
Bank balances
Trade receivables (including any marketable securities)
Short‑term, readily marketable investments

Inventory and pre‑payments are **excluded** because they are not easily convertible to cash.

3.3 Formula

$$\textbf{Acid‑Test Ratio} = \frac{\textbf{Current Assets} - \textbf{Inventory}}{\textbf{Current Liabilities}} \;=\; \frac{\textbf{Quick Assets}}{\textbf{Current Liabilities}}$$

3.4 Interpretation

• Ratio > 1 – The firm can meet short‑term liabilities without selling inventory.
• Ratio = 1 – Quick assets just cover current liabilities.
• Ratio < 1 – The firm may need to liquidate inventory or obtain extra financing to settle obligations.
• Extremely high values can also signal that cash is being held idle rather than invested.

3.5 Limitations

• Quality of receivables is not considered – doubtful debts may overstate liquidity.
• Cash‑flow timing is ignored; a good quick ratio does not guarantee cash will be available when needed.
• Industry benchmarks vary; a quick ratio of 0.8 may be acceptable in capital‑intensive sectors.

4. Linking Liquidity Ratios to Other Financial Concepts

• Working Capital:
  Working Capital = Current Assets – Current Liabilities.
  A positive working capital usually supports a current ratio above 1.
• Cash‑Flow Management: Both ratios are static snapshots; the cash‑flow statement shows the actual movement of cash over a period.
• Profitability: Highly profitable firms may tolerate a lower liquidity ratio because future cash inflows are expected.
• Credit Rating: Lenders often look at both ratios when deciding loan terms and interest rates.

5. Worked Example

ABC Ltd. – Balance‑sheet extracts (all figures in £’000)

Item	Amount (£’000)
Cash	50
Trade Receivables	120
Inventory	80
Pre‑payments	10
Current Liabilities	200

Step 1 – Calculate Current Assets

Current Assets = Cash + Trade Receivables + Inventory + Pre‑payments

$$\text{Current Assets}=50+120+80+10=260$$

Step 2 – Current Ratio

$$\text{Current Ratio}= \frac{\textbf{Current Assets}}{\textbf{Current Liabilities}} = \frac{260}{200}=1.30$$

Interpretation: For every £1 of current liabilities, ABC Ltd. has £1.30 of current assets – a satisfactory liquidity position.

Step 3 – Quick (Acid‑Test) Ratio

Quick Assets = Current Assets – Inventory = 260 – 80 = 180

$$\text{Acid‑Test Ratio}= \frac{180}{200}=0.90$$

Interpretation: The firm has £0.90 of quick assets for every £1 of current liabilities, indicating a slight shortfall if inventory cannot be sold quickly.

Step 4 – Working Capital Check

Working Capital = Current Assets – Current Liabilities = 260 – 200 = £60 000 (positive, supporting the current ratio).

6. Practice Questions (Mark‑Scheme Highlights)

1. XYZ Co. (Figures in $’000):
   Cash $30, Trade Receivables $70, Inventory $50, Pre‑payments $5, Current Liabilities $120.
   Answer:
   • Current Assets = 30 + 70 + 50 + 5 = $155.
   • Current Ratio = 155 ÷ 120 = 1.29 → adequate liquidity (ratio > 1).
   • Quick Assets = 155 – 50 = $105.
   • Acid‑Test Ratio = 105 ÷ 120 = 0.88 → slightly below 1, showing reliance on inventory.
   Interpretation: The firm is generally liquid but would be vulnerable if inventory sales slow down.
2. Company A – Current Ratio 2.5, Acid‑Test Ratio 0.8.
   Interpretation: A large proportion of current assets is tied up in inventory (or other non‑quick assets). The firm can cover its liabilities on paper, but without selling inventory it would struggle.
3. Explain two reasons why a business might deliberately keep its current ratio below 2.0.
   Possible points (2 marks each):
   • To avoid the opportunity cost of holding excess cash or inventory that could earn a higher return elsewhere.
   • Because a very high ratio may signal poor asset utilisation, potentially lowering investor confidence.
   • In capital‑intensive industries, a lower ratio is normal; firms rely more on long‑term financing than on short‑term liquidity.

7. Summary Checklist (Exam‑Style)

• Identify **all** current assets and current liabilities from the balance sheet.
• Calculate **Current Assets** first, then apply the two formulas exactly as written.
• Remember: Quick assets = Current assets – Inventory (pre‑payments are also excluded).
• State each ratio to two decimal places (e.g., 1.30).
• Interpret each result:
  • Is it > 1, = 1, or < 1?
  • Is it unusually high?
  • What does it reveal about the composition of current assets?
• Comment on any limitations or industry‑specific considerations.