Using Liquidity Ratios To Analyse Performance (Cambridge International IGCSE Business)
Liquidity ratios
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Liquidity refers to the cash and other current assets businesses have available to quickly pay bills and meet short-term financial obligations
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The liquidity of a business can be measured using two ratios
- Current ratio
- Acid test ratio
The current ratio
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The Current Ratio is a quick way to measure liquidity
- The outcome is expressed as a ratio
- All types of current asset are included in calculating this ratio
- The result indicates how many £s(or other currency units) of current assets are available to cover each £1 (or other currency unit) of short-term debt
- It is calculated using the formula
Worked Example Packer Sports Ltd has current assets of $15,545, current liabilities of $5,060 and an inventory (stock) figure of $8,250.
Calculate Packer Sports Ltd.’s current ratio.
(2)
Step 1: Substitute the values into the equation
\ 15 , 545 \div $ 5 , 060
= 3.07$ [1]
Step 2: Express the outcome as a ratio
[1]
In this example, Packer Sports Ltd has $3.07 of current assets to cover each $1 of short-term debt**
The acid test ratio
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The acid test ratio is a precise and realistic way to measure liquidity, especially for businesses that hold large amounts of stock
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It is expressed as a ratio
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It is also known as the liquid capital ratio
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The least liquid form of current assets (stock) is deducted so the acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly
- It often takes time to sell stock so it is excluded
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The Acid Test is calculated using the formula
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Worked Example Packer Sports Ltd has current assets of $15,545, current liabilities of $5,060 and a stock figure of $8,250.
Calculate Packer Sports Ltd’s acid test ratio.
[3]
Step 1: Subtract stock from current assets
\ 15 , 545 - $ 8 , 250
= $ 7 , 295$ [1]
Step 1: Substitute the values into the equation
$\text{Acid} \text{test} \text{ratio} = \frac{ \text{Current} \text{assets} - stock}{Current liabilities}
= \frac{ $ 7 , 295}{$ 5 , 060}
= 1.44$ **[1]
** Step 2: Express the outcome as a ratio
**[1]
** In this example, Packer Sports Ltd has $1.44 of the most liquid current assets to cover each $1 of short-term debt**
Improving liquidity ratios
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The best way to improve liquidity is to manage the business better
- Use cash flow forecasts to identify potential cash flow issues before they arise and take appropriate action
- Budget effectively and consider adopting zero budgeting to carefully control spending
- Set clear financial objectives and look for ways to reduce costs and increase income wherever possible
Methods to improve liquidity
| Method | Explanation |
|---|---|
| Reduce the credit period offered to customers | - Collecting money owed from customers more quickly will **increase the level of current assets **in the business - Customers may move to competing businesses that offer better credit terms |
| Ask suppliers for an extended repayment period, e.g an extension from 60 to 90 days | - Current liabilities will not be reduced - The business can use cash it would have paid to suppliers for other purposes - Suppliers may be unwilling to extend credit terms |
| Make use of overdraft facilities or short-term loans | - Current liabilities will** increase** - The business can spend more money than it has in its bank account - Banks may be reluctant to lend to businesses with cash-flow problems |
| Sell off excess stock | - Less liquid current assets will be reduced and converted into more liquid forms of current asset(e.g. cash) - Storage and security costs may also be reduced - Stock may need to be sold at a low price to attract sales |
| Sell assets and lease fixed assets instead(e.g. sale and leaseback) | - Both current assets and current liabilities will increase - The business will continue to have the use of assets but must make regular payments to the leasing company |
| Introduce new capital and reduce drawings out of the business | - Current assets will be increased - New capital may be introduced by the owner or from additional investors - This may result in the dilution of control of the business |
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