10.2 Analysis of Published Accounts – Liquidity Ratios
Objective: Current Ratio – Calculation & Interpretation
The current ratio is a quick check to see if a company can cover its short‑term debts with its short‑term assets. Think of it as a safety net that tells you whether the company has enough “cash‑on‑hand” to pay its bills if they come due soon. 📈
Analogy: Imagine you’re planning a road trip. Your current assets are the fuel in your tank, and your current liabilities are the tolls and gas stations you need to pay for along the way. If you have more fuel than the total cost of the tolls, you’re safe to keep driving. If not, you might run out of gas before you finish the trip. 🛣️
Step‑by‑Step Calculation
- Identify current assets from the balance sheet (cash, accounts receivable, inventory, etc.).
- Identify current liabilities (accounts payable, short‑term debt, etc.).
- Apply the formula:
\$Current\ Ratio = \dfrac{Current\ Assets}{Current\ Liabilities}\$ - Round to two decimal places for reporting.
Example Calculation
| Item | Amount (£) |
|---|
| Current Assets | $120,000 |
| Current Liabilities | $80,000 |
| Current Ratio | $1.50 |
A current ratio of 1.50 means the company has £1.50 in current assets for every £1 of current liabilities. In other words, it can comfortably cover its short‑term debts. 💡
Interpretation & What It Tells You
- Ratio > 1 – The company has more current assets than liabilities; it is likely to meet short‑term obligations.
- Ratio = 1 – Assets exactly cover liabilities; any unexpected expense could strain liquidity.
- Ratio < 1 – The company may struggle to pay short‑term debts; it could face liquidity risk.
- Higher ratios are generally better, but an excessively high ratio might indicate under‑utilised assets.
Exam Tip: When answering ratio questions, always:
- Show the formula clearly.
- Plug in the figures from the balance sheet.
- State the result and interpret it in one or two sentences.
- Use the word liquidity to link your answer to the topic.