### ZIMSEC O Level Business Studies Notes: Business Finance and Accounting: Ratio Analysis: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

#### Current Asset Ratio

• 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

#### Quick Asset Ratio/Acid Test Ratio

• 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 theĀ O Level Business Notes

By |2018-01-22T08:52:57+00:00July 5th, 2017|Notes, O Level Business Studies Notes, Ordinary Level Notes|Comments Off on Business Studies: Liquidity ratios

### About the Author: Garikai Dzoma

He holds an Honours in Accountancy degree from the University of Zimbabwe. He is passionate about technology and its practical application in today's world.