Study Notes: Business Finance & Accounting

Liquidity rations (current & acid-test)

There are two main liquidity ratios which are used to help assess whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due. In other words, the liquidity ratios focus on the solvency of the business.  A business that finds that it does not have the cash to settle its debts becomes insolvent.

Liquidity ratios focus on the short-term and make use of the current assets and current liabilities shown in the balance sheet.

Current ratio

This is a simple measure that estimates whether the business can pay debts due within one year out of the current assets. A ratio of less than one is often a cause for concern, particularly if it persists for any length of time.

The formula for the current ratio is:

The calculation for the current ratio can be illustrated as follows:

At 31 December 2012 current assets were 1.85 times the value of current liabilities. That ratio was more than the 1.7 times at the end of 2011, suggesting a slight improvement in the current ratio.

A current ratio of around 1.7-2.0 is pretty encouraging for a business.  It suggests that the business has enough cash to be able to pay its debts, but not too much finance tied up in current assets which could be reinvested or distributed to shareholders.

A low current ratio (say less than 1.0-1.5 might suggest that the business is not well placed to pay its debts.  It might be required to raise extra finance or extend the time it takes to pay creditors.

Acid-test ratio

Not all assets can be turned into cash quickly or easily. Some - notably raw materials and other stocks - must first be turned into final product, then sold and the cash collected from debtors.

The Acid Test Ratio (sometimes also called the “Quick Ratio”) therefore adjusts the Current Ratio to eliminate certain current assets that are not already in cash (or "near-cash") form. The tradition is to remove inventories (stocks) from the current assets total, since inventories are assumed to be the most illiquid part of current assets – it is harder to turn them into cash quickly.

The formula for the acid test ratio is:

An example calculation is shown below:

Again, the data for the business looks fine.  An acid test ratio of over 1.0 is good news; the business is well-placed to be able to pay its debts even if it cannot turn inventories into cash.

Some care has to be taken interpreting the acid test ratio.  The value of inventories a business needs to hold will vary considerably from industry to industry.  For example, you wouldn’t expect a firm of solicitors to carry much inventory, but a major supermarket needs to carrying huge quantities at any one time. 

An acid test ratio for Tesco or Asda would indicate a very low figure after taking off the value of inventories but leaving in the very high amounts owed to suppliers (trade creditors).  However, there is no suggestion that either of these two businesses has a problem being able to pay its debts!

The trick is to consider what a sensible figure is for the industry under review.  A good discipline is to find an industry average and then compare the current and acid test ratios against for the business concerned against that average.