Liquidity Ratios

Liquidity Ratios

There are two main ratios that can be used to measure the liquidity of a business:

  1. The current ratio
  2. The 'acid-test' ratio

The current ratio. This measures current assets as a proportion of current liabilities. It is calculated using the following formula:

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For example, if a business has current assets of £250,000 and current liabilities of £180,000, then the current ratio would be:

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This means that for every £1 of current liabilities, the business has £1.39 of current assets available. Ideally, the answer should be between 1.5 and 2. A figure less than 1.5 indicates that the business may experience difficulties in meeting its short-term debts (i.e. a liquidity crisis). An answer of more than 2 indicates that the business may be holding cash in an unproductive and unprofitable form, and it may be better used elsewhere.

The 'acid-test' ratio. This measures current assets less stock as a proportion of current liabilities. It is calculated using the following formula:

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Stock is excluded because a business may not be able to convert it into cash quickly. For example, if a business has current assets less stock of £150,000 and current liabilities of £180,000, then the current ratio would be:

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This means that for every £1 of current liabilities, the business has £0.83 of cash available at short-notice. Ideally, the answer should be between 1 and 1.2. A figure less than 1 indicates that the business may experience difficulties in meeting its short-term debts (i.e. a liquidity crisis). An answer of more than 1.2 indicates that the business may be holding cash in an unproductive and unprofitable form, and it may be better used elsewhere.

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