Liquidity Ratios (Cambridge International IGCSE Accounting)

What are liquidity ratios?

• Liquidity ratios are ways to measure how quickly a business can convert assets into cash

  • They compare the current assets to the current liabilities

• The liquidity ratios are:

  • Current ratio
  • Liquid (acid test) ratio

Current ratio

Spec point — 6.1.4

What is the current ratio?

• The current ratio is also known as the working capital ratio

  • Working capital is current assets minus current liabilities

• A ratio close to 2:1 is generally good

  • If it is less than 1:1 then the business does not have enough current assets to cover its current liabilities

  • If it is too high then the business could have too much inventory or trade receivables

    • They need to improve their inventory control
    • They need to encourage credit customers to pay faster

Worked Example Elena and Tom are in a partnership. They provide the following information at 31 March 2024.

	$
Trade receivables	34 000
Trade payables	28 000
Inventory	20 000
Bank	5 000
Other payables	4 000

Calculate the current ratio. Your answer should be correct to two decimal places.

Answer:

• Calculate the total current assets

  • Trade receivables + Inventory + Bank

$34 000 + $20 000 + $5 000 = $59 000

• Calculate the total current liabilities

  • Trade payables + Other payables

$28 000 + $4 000 = $32 000

• Calculate the current ratio

  • $\frac{\mathrm{Current} \mathrm{assets}}{\mathrm{Current} \mathrm{liabilities}}$

$\frac{59000}{32000}=1.84375$

• Round to two decimal places and write as a ratio

Final answer: Current ratio = 1.84 : 1

Liquid (acid test) ratio

Spec point — 6.1.5

What is the liquid (acid test) ratio?

• The liquid ratio is also known as the acid test or the quick ratio
• It measures how well current liabilities are covered by the more liquid forms of current assets—cash and trade receivables

• A ratio close to 1:1 is generally good

  • If it is above 1:1 then the business has enough liquid assets to cover its short-term debts even if the inventory cannot be sold

  • If it is too high then the business could be owed too much by trade receivables

    • They need to encourage credit customers to pay faster

Exam Hint You can either subtract the inventory from the total current assets or add up all the current assets excluding the inventory.

Worked Example Elena and Tom are in a partnership. They provide the following information at 31 March 2024.

	$
Trade receivables	34 000
Trade payables	28 000
Inventory	20 000
Bank	5 000
Other payables	4 000

Calculate the liquid (acid test) ratio. Your answer should be correct to two decimal places.

Answer:

• Calculate the total current assets excluding the inventory

  • Trade receivables + Bank

$34 000 + $5 000 = $39 000

• Calculate the total current liabilities

  • Trade payables + Other payables

$28 000 + $4 000 = $32 000

• Calculate the liquid ratio

  • $\frac{\mathrm{Current} \mathrm{assets}-\mathrm{Inventory}}{\mathrm{Current} \mathrm{liabilities}}$

$\frac{39000}{32000}=1.21875$

• Round to two decimal places and write as a ratio

Final answer: Liquid (acid test) ratio = 1.22 : 1

Evaluating liquidity

How do I evaluate the liquidity of a business?

• The liquid ratio is the best indicator of the liquidity of a business

• However, it is helpful to look at both ratios together

• The difference between the two ratios tells you about the proportion of the current assets that are made up of inventory

  • The current ratio might be good but the liquid ratio might be too low

    • This suggests the business has a lot of money tied up in inventory

  • The ratios might be very similar

    • This suggests the business does not have a lot of inventory
    • This means they might not have sufficient supplies to meet demand

• If both ratios are too low then:

  • The business might not be able to repay short-term debts on time
  • The business might not have the resources to pay credit suppliers quickly and therefore miss out on cash discounts
  • The owner(s) might not be able to take drawings

• Pay attention to whether the goods are purchased and sold on credit or cash

  • If goods are purchased using cash then there will be no trade payables

  • If goods are sold for cash then there will be no trade receivables

    • This might not affect the current assets as the bank increases instead of the trade receivables

How do I compare the liquidity of a business between years?

• Compare the ratios to the same ratios from previous years

• For each ratio

  • Make a general comment

    • State whether it has improved or gotten worse
    • State the ratios

  • Give possible reasons for the change

• Possible reasons for a decrease in the ratios

  • Less cash or a higher bank overdraft due to

    • Purchase of a non-current asset
    • Increase in drawings
    • Repayment of long-term loans

  • Decrease in other current assets

    • Trade receivables

  • Increase in current liabilities

    • Trade payables
    • Short-term loans

• Possible reasons for an increase in the ratios

  • More cash or a lower bank overdraft due to

    • Sale of a non-current asset
    • Decrease in drawings
    • New long-term loans

  • Increase in other current assets

    • Trade receivables

  • Decrease in current liabilities

    • Trade payables
    • Short-term loans

Worked Example Tala is a sole trader and her financial year ends 31 March. She provides the following information.

	At 31 March 2023	At 31 March 2024
Current ratio	1.56 : 1	0.94 : 1
Liquid (acid test) ratio	1.03 : 1	0.79 : 1

(a) Suggest two reasons for the change in the ratios.

(b) Suggest two reasons why Tala should aim to increase the ratios.

Answer:

(a)

• State two reasons why both ratios could have decreased
• As both have decreased then this suggests there has not been a decrease in the inventory

Final answer: The current ratio has worsened by decreasing from 1.56 : 1 to 0.94 : 1 and the liquid ratio has also worsened by decreasing from 1.03 : 1 to 0.79 : 1.

Final answer: One possible reason is that Tala might have purchased a non-current asset for cash which would decrease the current assets. Alternatively, she might have used a short-term loan to purchase the non-current asset, which would have increased the current liabilities

Final answer: Another possible reason is that Tala might have increased the amount of drawings in the form of cash. This would decrease the money in the bank.

(b)

• State two reasons why it is better to have higher ratios

Final answer: One reason why Tala should increase her ratios is so that she is able to repay her short-term debts without incurring late charges or interest.

Final answer: Another reason to increase the ratios is so that Tala has enough funds to pay for the business expenses without requiring further short-term loans.