Liquidity ratios — common mistakes

In exam answers, do not just state the ratio results. You must interpret them in the context of the business in the case study. For example, explain why a high inventory level might be a problem for that specific business and therefore why the acid test ratio is a more relevant indicator than the current ratio. Always use the data to justify your conclusions.

Interpretation must be in context — a retailer's acid test is often lower than a service business with no inventory.

Not necessarily. While it indicates a strong ability to cover short-term debts, a very high current ratio (e.g., 5:1) can signal inefficiency. It may mean that too much cash is sitting idle instead of being invested, or that capital is tied up in excessive inventories or trade receivables, which could harm profitability.

Yes, absolutely. Profit is the difference between revenues and costs over a period, whereas liquidity relates to cash flow. A business can make a large credit sale, which increases profit, but if the customer does not pay for a long time, the business will not have the cash to pay its own suppliers, potentially leading to insolvency. This is a classic example of 'overtrading'.

The acid test ratio is more stringent because it removes inventories from the calculation. Inventories can be difficult to sell quickly, may become obsolete, or might only be sellable at a significant discount. By excluding them, the ratio only considers the most liquid assets (cash, bank, and trade receivables) against current liabilities, giving a more cautious and immediate picture of a firm's ability to pay its bills.