Liquidity Ratios – A Level Business CAIE Revision

Understanding Liquidity Ratios

Liquidity ratios are critical tools in accounting to assess a business’s ability to pay off its short-term liabilities.
They are derived by comparing different types of company’s assets to its short-term liabilities.
High liquidity ratios indicate a better ability to cover short-term obligations, signifying financial stability.
However, excessively high ratios may suggest that the company’s assets are not being used optimally to generate profits.

Current Ratio: This ratio indicates the ability of an entity to repay its short-term obligations with short-term or current assets.
- Current Ratio is calculated as Current Assets / Current Liabilities.
Quick Ratio or Acid Test Ratio: A more stringent test of liquidity, it excludes inventories in the calculation.
- Quick Ratio is calculated as (Current Assets – Inventories) / Current Liabilities.
Cash Ratio: This is the most stringent liquidity ratio which only takes into account the most liquid form of assets i.e., cash and cash equivalents.
- Cash Ratio is calculated as Cash and Cash Equivalents / Current Liabilities.

Understanding the absolute values of liquidity ratios is vital - A Current Ratio of 2:1 and an Acid Test Ratio of 1:1 is generally seen as healthy.
However, these ratios need to be industry specific, as a good ratio in one industry may not mean the same in another. Always compare with industry benchmarks if available.
Consider the company’s business cycle and seasonality, as these can affect a company’s liquidity position at a particular point of time.

They do not consider the quality of current assets, which can highly affect the liquidity position of the business.
The value of these ratios depends on the speed at which the current assets can be converted into cash.
These ratios are based on accounting values rather than realisable values. When asset values in the balance sheet do not reflect current market values, the ratios can be misleading.

When examining the Current Ratio, remember that a ratio less than 1 may indicate that the company cannot meet its short-term obligations without additional financial support.
While checking the Acid Test Ratio, bear in mind that a ratio of 1 or higher indicates that the company can pay off its short-term liabilities without selling inventory - a good sign of financial health.
In application of the Cash Ratio, note that a high ratio means the company has cash available for contingencies, but also might imply that cash is not being sufficiently reinvested for growth.