Liquidity Ratios (Cambridge International AS Accounting)
What are liquidity ratios?
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Liquidity ratios are ways to measure how quickly a business can convert assets into cash
- They compare the current assets to the current liabilities
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The liquidity ratios are:
- Current ratio
- Acid test ratio
Current ratio
Spec point — how to calculate key accounting ratios to measure liquidity: – liquidity ratios: current ratio, acid test ratio
Current ratio
What is the current ratio?
- It is also known as the working capital ratio
- Working capital is current assets minus current liabilities
| What is the formula? | |
|---|---|
| How should the value be written? | Write as a ratio (X : 1) |
| How should the value be rounded? | Round to two decimal places |
| What does the value mean? | The value represents the amount of current assets available to cover each $1 of current liability |
| How can the ratio be increased? | - Increase current assets by introducing capital or selling non-current assets - Reduce current liabilities, such as overdrafts and trade payables |
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A ratio close to 2:1 is generally good
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If it is less than 1:1 then the business does not have enough current assets to cover its current liabilities
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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
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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
- Round to two decimal places and write as a ratio
Final answer: Current ratio = 1.84 : 1
Acid test ratio
Spec point — how to calculate key accounting ratios to measure liquidity: – liquidity ratios: current ratio, acid test ratio
Acid test ratio
What is the acid test ratio?
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This ratio is also known as the quick ratio or the liquid ratio
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It measures how well current liabilities are covered by the more liquid forms of current assets
- The most liquid forms are cash and trade receivables
| What is the formula? | |
|---|---|
| How should the value be written? | Write as a ratio (X : 1) |
| How should the value be rounded? | Round to two decimal places |
| What does the value mean? | The value represents the amount of cash and receivables available to cover each $1 of current liability |
| How can the ratio be increased? | - Increase current assets, especially cash, by introducing capital or selling non-current assets - Reduce current liabilities, such as overdrafts and trade payables |
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A ratio close to 1:1 is generally good
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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
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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
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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 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 acid test ratio
- Round to two decimal places and write as a ratio
Final answer: Acid test ratio = 1.22 : 1
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