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Liquidity Ratios

Liquidity ratios assess a firm's ability to pay short-term debts by analyzing working capital. The current ratio compares current assets to current liabilities, with a recommended ratio of 1.5-2. The acid test ratio is a stricter measure that excludes inventories from current assets, providing a clearer picture of liquidity. Both ratios can indicate if a firm has too little working capital and risks insolvency, or too much tied up in unprofitable current assets. Managers may take actions like selling assets to improve cash position if liquidity is low.

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78 views

Liquidity Ratios

Liquidity ratios assess a firm's ability to pay short-term debts by analyzing working capital. The current ratio compares current assets to current liabilities, with a recommended ratio of 1.5-2. The acid test ratio is a stricter measure that excludes inventories from current assets, providing a clearer picture of liquidity. Both ratios can indicate if a firm has too little working capital and risks insolvency, or too much tied up in unprofitable current assets. Managers may take actions like selling assets to improve cash position if liquidity is low.

Uploaded by

abrar mahir Sahil
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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LIQUIDITY RATIOS

 These ratios asses the ability of the firm to pay its short term debts.
 Concerned with working capital of the business.
 If there is too little working capital then business could become illiquid and fail to settle short
term debts.
 On the other hand, if there is too much money tied up in working capital, then this could be
used more effectively and profitability by investing in other assets.

Current Ratio
 This compares the current assets with the current liability of the business .
 Current ratio= current assets
Current liabilities
 Result can either be expressed as ratio (2:1) or just a number (2)
 The recommended result is 1.5-2, but much depends on the industry the firm operates in and
recent trend in the current ratio.
 A result of 1:1 means $1 of worth of asset is present to pay for $1 liability and it is risky. Very
low current ratio might not be usual for businesses that have regular inflows of cash such as
cash sales, that they rely on to pay short term debts.
 Current ratio over 2 might mean money is tied up in unprofitable inventories, debtors and cash
and thus have better usage.
 A low current ratio might lend to corrective management action to improve cash position.
 Sale of redundant assets, cancelling capital spending plans, share issue or taking long term
loans.

Acid Test Ratio


 Liquid assets
Current liabilities
 Liquid assets=Current Assets – Inventories
 Also known as quick ratio
 A stricter test of firm’s liquidity by ignoring the least liquid current asset i.e. inventories (stock)
 Inventories are not yet sold and there can be no certainty that they will be sold in the short
term.
 By eliminating the value of inventories, a clearer picture of the firms ability to pay short term
debts can be visualized.
 Firms with very high inventory will record very different current and acid test ratio.
 For some businesses too much inventory is not a problem unless the inventory becomes
obsolete with time due to technological changes.
 Although selling inventories for cash will not improve current ratio (as both items are include in
current assets) but it will improve acid test ratio as cash is a liquid asset, but inventories are not.
 The better analysis will need comparison with previous years result (if available)
 Ways to improve liquidity
- Sell off fixed assets for cash : true value might not be raised if sold quickly, might be needed
in future, if leased back then leasing cost.
- Sell off inventories for cash: will improve acid test ratio but not current ratio, reduce gross
profit margin of inventories sold at discount, consumers may doubt because of low price,
inventories might be needed in charging customer demands.
- Increase loans to inject cash into the business and increase working capital: will increase
gearing ratio, increase interest cost.

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