Business Studies – 5.5.2 Liquidity | e-Consult

Current Ratio Calculation:

Current Assets = Stock + Debtors + Cash = £12,000 + £20,000 + £5,000 = £37,000

Current Ratio = Current Assets / Current Liabilities = £37,000 / £10,000 = 3.7

Interpretation: A current ratio of 3.7 indicates that XYZ Company has £3.70 of current assets for every £1 of current liabilities. This is a very strong liquidity position. It suggests the company has ample resources to cover its short-term debts. A ratio this high might indicate that the company is not effectively utilizing its current assets, such as holding too much cash or inventory.

Acid Test Ratio Calculation:

Acid Test Assets = Debtors + Cash = £20,000 + £5,000 = £25,000

Acid Test Ratio = Acid Test Assets / Current Liabilities = £25,000 / £10,000 = 2.5

Interpretation: The acid test ratio of 2.5 shows that XYZ Company has £2.50 of acid test assets for every £1 of current liabilities. This is also a very healthy liquidity position. It indicates that even without relying on inventory, the company has sufficient liquid assets to meet its immediate obligations. This is a positive sign for the company's ability to pay its debts.

What the Ratios Reveal:

• The high current ratio and acid test ratio for XYZ Company demonstrate a strong ability to meet its short-term liabilities.
• The company has a significant buffer of liquid assets, which reduces the risk of financial distress.
• The ratios suggest that the company is well-managed and has effective working capital management.
• However, it's important to consider the industry context. While these ratios are strong, they should be compared to industry averages to determine if they are truly optimal.