What is liquidity?
→ Liquidity is the ability of a business to pay its short-term debts and obligations when they become due.
→ Short-term obligations are usually liabilities that must be paid within one year, such as:
- trade payables
- short-term loans
- overdrafts
- accrued expenses
- tax payable
→ A business needs enough current assets to meet these short-term liabilities.
→ Current assets include:
- inventory
- trade receivables
- cash and bank balances
Why is liquidity important?
→ Avoids cash-flow problems → the business can pay suppliers, employees and other creditors on time.
→ Maintains supplier confidence → suppliers are more likely to continue offering credit.
→ Maintains creditworthiness → banks and lenders may be more willing to provide finance.
→ Supports day-to-day operations → the business can continue operating without interruptions caused by unpaid bills.
→ Reduces risk of insolvency → insufficient liquidity can make it difficult for a business to meet its short-term obligations.
→ Supports business reputation → regularly paying debts on time can improve the business’s reputation with suppliers and other stakeholders.
→ However, too much liquidity may also be inefficient. For example, keeping large amounts of cash that could have been invested may mean the business is not using its resources effectively.
Current Ratio
Meaning
→ The current ratio measures whether a business has enough current assets to cover its current liabilities.
Formula
Current ratio = Current assets ÷ Current liabilities
→ The answer is expressed as a ratio, for example 2 : 1.
Example
A business has:
- Current assets = $120,000
- Current liabilities = $60,000
Current ratio = $120,000 ÷ $60,000 = 2 : 1
→ This means the business has $2 of current assets for every $1 of current liabilities.
Interpretation
→ Higher current ratio → generally indicates a stronger ability to meet short-term obligations.
→ Lower current ratio → may indicate greater liquidity risk because the business has fewer current assets available to meet its short-term liabilities.
→ A current ratio that is too high may suggest that resources are being tied up in inventory, receivables or cash rather than being used productively.
→ A current ratio that is too low may indicate difficulty paying suppliers and other short-term creditors.
What can affect the current ratio?
→ The interpretation should consider the type of business.
→ A supermarket may operate successfully with a relatively low ratio because it receives cash quickly from customers.
→ A manufacturing business may need more working capital because money can remain tied up in inventory and receivables for longer.
Acid Test Ratio
Meaning
→ The acid test ratio, also called the quick ratio, measures whether a business can pay its current liabilities without relying on the sale of inventory.
→ Inventory is excluded because it may take time to sell and may not always be converted into cash immediately.
Formula
Acid test ratio = (Current assets − Inventory) ÷ Current liabilities
It can also be written as:
Acid test ratio = (Cash + Trade receivables) ÷ Current liabilities
Example
A business has:
- Current assets = $120,000
- Inventory = $40,000
- Current liabilities = $60,000
Acid test ratio = ($120,000 − $40,000) ÷ $60,000
= $80,000 ÷ $60,000
= 1.33 : 1
→ The business has $1.33 of quick assets for every $1 of current liabilities.
Interpretation
→ Higher acid test ratio → generally indicates a greater ability to meet short-term liabilities without selling inventory.
→ Lower acid test ratio → may indicate greater dependence on selling inventory to obtain cash.
→ If the acid test ratio is below 1 : 1, the business has fewer quick assets than current liabilities.
→ This does not automatically mean the business will fail. A business may have rapid inventory turnover or reliable cash inflows that allow it to pay its liabilities.
Why is the acid test ratio useful?
→ It provides a more cautious measure of liquidity than the current ratio.
→ It removes inventory, which may be the least liquid current asset.
→ Comparing the two ratios can reveal how much of the business’s liquidity depends on inventory.
Current Ratio vs Acid Test Ratio
| Current Ratio | Acid Test Ratio |
|---|---|
| Includes all current assets | Excludes inventory |
| Measures overall short-term liquidity | Measures more immediate liquidity |
| Includes inventory | Focuses on cash and near-cash assets |
| Formula: Current assets ÷ Current liabilities | Formula: (Current assets − inventory) ÷ Current liabilities |
| Less strict measure | More strict measure |
→ Current ratio higher than acid test ratio because inventory is included in the current ratio.
→ A large difference between the two ratios may indicate that a significant proportion of current assets is tied up in inventory.
Methods of Improving Liquidity
Increase cash inflows
→ Increase sales for cash → more cash enters the business → liquidity improves.
→ Sell unused assets → cash is generated without increasing borrowing.
→ Owner/shareholder capital injection → additional cash becomes available to pay short-term obligations.
Reduce cash outflows
→ Delay non-essential expenditure → less cash leaves the business immediately.
→ Reduce unnecessary expenses → more cash remains available for short-term payments.
Improve trade receivables
→ Collect debts from customers faster → trade receivables are converted into cash sooner.
→ Offer early-payment discounts → customers may pay more quickly, although the discount reduces the amount received.
→ Improve credit control → check customers’ creditworthiness and set appropriate credit limits.
Manage inventory
→ Reduce excess inventory → less cash is tied up in unsold stock.
→ Use JIT inventory management where appropriate → inventory is purchased closer to when it is needed.
→ Sell obsolete or slow-moving inventory → converts stock into cash.
Manage trade payables
→ Negotiate longer payment periods with suppliers → the business keeps cash for longer.
→ However, delaying payments too much may damage supplier relationships or cause suppliers to withdraw credit.
Obtain additional short-term finance
→ Arrange an overdraft or other short-term finance → provides cash to meet temporary liquidity shortages.
→ However, borrowing increases financial obligations and may increase interest costs.
Improve liquidity — decision chain
→ Faster collection of receivables → cash increases → current assets become more liquid → liquidity improves.
→ Reduce excess inventory → cash is released → quick assets increase → acid test ratio improves.
→ Longer supplier credit period → current liabilities are paid later → cash is retained for longer → liquidity improves.
→ Reduce unnecessary expenditure → cash outflows decrease → cash balance increases → liquidity improves.
Key exam point
→ Liquidity is about the ability to pay short-term debts, not simply whether a business is profitable.
→ A business can make a profit but still have poor liquidity if too much money is tied up in inventory or trade receivables.
→ Therefore, when interpreting liquidity ratios, consider cash, receivables, inventory, payment periods and the nature of the business.