Business Studies: Liquidity ratios

Liquidity is a measure of how well a business can meet its short term obligations as and when they fall due
It is usually expressed in terms of how well the entity in question can convert its assets into cash
Short term obligations include amounts owed to creditors, bank overdraft, interest on debentures
Short term obligations are also known as current liabilities
These are amounts owing that have to be settled by the business within a period of one year or less
In accounting and finance liquidity is usually measured by how well current assets can meet current liabilities
Current assets comprise cash and other items that can be quickly converted into cash to pay creditors when they come calling
Liquidity ratios are therefore used to express the level of risk that a business will be able or not able to pay its creditors when they demand payment
There are two main ratios used to measure liquidity:
1. Current Asset Ratio
2. Acid Test Ratio/Quick Asset Ratio
Both make use of the concept of working capital and compare current assets to current liabilities

The ratio is calculated using the formula:
$\mathrm{Current \quad Ratio = \dfrac{Current\quad Assets}{Current\quad Liabilities}}$
For example let us say we have current assets of $3 000 and current liabilities of $ 1 500
The ratio would be calculated as follows:
$\mathrm{\dfrac{3000}{1500}}$
2
This means for every $1 in fixed there is $2 in current assets
In other terms there is twice as many current assets as there are current liabilities
The ratio is expressed as a number in decimal terms
Generally the current asset should be between 1.5 and 2
If it is any lower than this it means there is a real chance the business will face difficulties when trying to pay its creditors
If it is higher than this it means a lot of resources are tied up in the form of current assets

It is a more stringent/rigorous ratio
It is based on the realization that it might not be so easy to convert the item of stock into cash when creditors come knocking and the business has to pay
In such cases a business might even have to sell its stocks on discount in order to quickly raise cash
Including stock in determining liquidity can result in inaccuracies
The ratio recognizes this fact by deducting the asset of stock from current assets
The formula for the acid test ratio is:
$\mathrm{Acid \quad Test \quad Ratio = \dfrac{Current\quad Assets-Stock}{Current\quad Liabilities}}$
For example if the above mentioned business has stock valued at $ 1 500
Then the acid test ratio would be:
$\mathrm{\dfrac{3000-1500}{1500}}$
1
As a general rule a ratio of 1 is considered ideal
A lower ratio would mean that the business might be unable to meet its short term obligations
A higher ratio means money is tied up in the form of current assets which are unprofitable

To access more topics go to the O Level Business Notes

Business Studies: Liquidity ratios- Updated 2024