Liquid (acid test) ratio

6 Analysis and Interpretation – Accounting Ratios (Cambridge IGCSE 0452)

Liquid (Acid‑Test) Ratio

Definition & purpose (Syllabus 6.1)

• Measures a company’s ability to settle its short‑term obligations **without** having to sell inventory.
• Considered a stricter liquidity test than the current ratio because inventory may be illiquid or slow‑moving.
• Relevant for AO2 (calculate & select data) and AO3 (analyse & evaluate).

Formula

$$\text{Liquid (acid‑test) ratio}= \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}$$

Components (what to include)

• Current assets (most liquid): cash, bank balances, marketable securities, trade receivables, short‑term investments, prepaid expenses.
• Inventory: stock of goods held for sale – excluded from the numerator.
• Current liabilities: amounts payable within one year (trade payables, short‑term borrowings, accrued expenses, the current portion of long‑term debt).

Step‑by‑step calculation (AO2)

1. Locate the balance sheet for the reporting date.
2. Identify and add together **all** current‑asset items → Total current assets.
3. Read the figure for **Inventory** and subtract it from total current assets → Adjusted current assets.
4. Read the total of **Current liabilities**.
5. Apply the formula: Adjusted current assets ÷ Current liabilities.
6. Round the answer to two decimal places (or as required by the exam).

Worked example (AO1 + AO2)

ABC Ltd. (figures in £’000) – balance sheet date 31 December 2025

Calculation

• Adjusted current assets = 240 – 150 = 90  (£'000)
• Liquid ratio = 90 ÷ 200 = 0.45

Numeric trend illustration (Syllabus 6.2)

Suppose the same company reported the following liquid ratios:

• 2023: 1.20
• 2024: 0.95

The fall from >1 to <1 suggests a weakening liquidity position – an examiner would expect you to comment on possible causes (e.g., increase in inventory, slower collection of receivables, higher short‑term borrowing).

Interpretation of the result (AO3)

• Ratio > 1 – liquid assets exceed current liabilities; the firm can comfortably meet short‑term debts.
• Ratio = 1 – liquid assets just cover current liabilities; there is no margin for error.
• Ratio < 1 – the firm may need to sell inventory, obtain additional finance, or renegotiate payment terms to settle its short‑term obligations.

Suggested comment structure (AO3)

1. State the numerical result.
2. Compare with the previous year (trend) or with the industry average (benchmark).
3. Explain the likely reasons for the level or change (e.g., credit policy, stock‑piling, seasonal effects).
4. Give a recommendation for the relevant interested party (bank, supplier, owner, etc.).

Inter‑firm comparison (Syllabus 6.3)

Numeric illustration

Interpretation

• Company X appears more liquid and would be viewed more favourably by banks and suppliers.
• However, the ratio alone does not reveal the quality of receivables, the nature of the industry (e.g., high‑stock‑turnover sectors) or seasonal timing of the balance sheet.

Why interested parties care (Syllabus 6.4)

Limitations of the liquid ratio (Syllabus 6.5)

• Ignores the **timing** of cash inflows and outflows – a high year‑end ratio may mask cash shortages earlier in the period.
• Assumes all trade receivables are collectible at full value; ageing of receivables or bad‑debt provisions can overstate liquidity.
• Does not consider the **quality** of short‑term investments – some may be illiquid or carry market risk.
• Seasonal businesses can produce misleading ratios if the balance sheet is taken at a peak (high inventory) or trough (low cash).
• Relates to broader limitations of accounting statements: historic‑cost measurement, omission of non‑financial information, and the fact that the balance sheet is a snapshot rather than a flow of cash.

Link to accounting principles (AO5)

• Prudence (conservatism): Excluding inventory avoids an overly optimistic view of liquidity.
• Matching principle: Current liabilities are matched with the most liquid current assets that are expected to settle them.
• Going‑concern: The ratio assumes the business will continue operating; a persistently low ratio may signal doubts about continuity.
• Historic cost: Values are recorded at purchase price, which may differ from current market values – especially for inventory and investments.
• Money measurement: Only monetary items are included; non‑monetary factors (e.g., brand reputation) are ignored.

Common pitfalls (AO2)

• Including inventory in the numerator – defeats the purpose of the acid‑test.
• Using total assets instead of current assets.
• Mixing figures from different dates (e.g., trial balance vs. balance sheet).
• Omitting the formula before substituting numbers – a frequent marking‑scheme requirement.
• Failing to round consistently or to the required number of decimal places.

Key points – quick revision

Practice questions (covering AO2, AO3 & AO5)

1. Calculation & basic interpretation (AO2 + AO3)
   XYZ Co. (figures in $'000):
   Cash = 45, Bank = 55, Trade receivables = 70, Short‑term investments = 20, Pre‑paid expenses = 10, Inventory = 90, Current liabilities = 150.
   Calculate the liquid ratio and comment on the company’s liquidity.
2. Data selection (AO2)
   The following extracts are taken from the trial balance of LMN Ltd.
   

   Account	Debit (£)	Credit (£)
   Cash	30,000
   Bank	70,000
   Trade receivables	55,000
   Inventory	120,000
   Pre‑paid expenses	5,000
   Trade payables		95,000
   Bank overdraft (current)		25,000

   Select the figures you need and compute the liquid ratio.
3. Analysis (AO3)
   Explain why a firm might have a high current ratio but a low liquid ratio. Provide at least two reasons.
4. Evaluation & recommendation (AO3 + AO5)
   Over the last year, a company’s liquid ratio fell from 1.30 to 0.95.
   
   • List three possible explanations for the decline.
   • Advise a bank whether it should continue to lend to the firm, referring to the ratio, its limitations and any relevant accounting principles.
5. Inter‑firm comparison (AO2 + AO3)
   Company A: liquid ratio = 1.10
   Company B: liquid ratio = 0.85
   Both operate in the same industry.
   Discuss which company is more attractive to a supplier and why the ratio alone may not give the whole picture.

How this fits into the Cambridge IGCSE 0452 syllabus

• 6.1 – Definition, formula, step‑by‑step calculation and worked example (AO1 + AO2).
• 6.2 – Interpretation, trend analysis and benchmark comparison (AO3).
• 6.3 – Inter‑firm comparison techniques (AO2).
• 6.4 – Uses by owners, banks, suppliers, investors, government & tax authorities (AO3).
• 6.5 – Limitations of the ratio, link to accounting principles and critical evaluation (AO5).