Liquidity ratios — practice questions

Current ratio = 240 000 ÷ 160 000 = 1.5 : 1

Acid test = (240 000 − 90 000) ÷ 160 000 = 150 000 ÷ 160 000 = 0.94 : 1

Comment: Current ratio suggests adequate cover, but acid test below 1:1 — without selling inventory, the firm may struggle to pay short-term debts. Consider reducing inventory or speeding up receivables collection.

Step 1: Calculate ratios for 2023

• Current Ratio: $\frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{500,000}{250,000} = 2.0$ Result: 2.0 : 1

• Acid Test Ratio: $\frac{\text{Current Assets} - \text{Inventories}}{\text{Current Liabilities}} = \frac{500,000 - 280,000}{250,000} = \frac{220,000}{250,000} = 0.88$ Result: 0.88 : 1

Step 2: Calculate ratios for 2022

• Current Ratio: $\frac{\text{Current Assets}}{\text{Current Liabilities}} = \frac{450,000}{220,000} = 2.05$ (to 2 d.p.) Result: 2.05 : 1

• Acid Test Ratio: $\frac{\text{Current Assets} - \text{Inventories}}{\text{Current Liabilities}} = \frac{450,000 - 200,000}{220,000} = \frac{250,000}{220,000} = 1.14$ (to 2 d.p.) Result: 1.14 : 1

Step 3: Comment on the change in liquidity

• Trend Analysis: The current ratio has remained stable and appears healthy (2.05:1 to 2.0:1). However, the acid test ratio has deteriorated significantly, falling from a safe 1.14:1 in 2022 to a concerning 0.88:1 in 2023.
• Interpretation: This indicates a growing liquidity problem masked by a large increase in inventories. In 2023, the company does not have enough liquid assets to cover its short-term debts without relying on selling its stock. The value of inventories has increased by $80,000 (a 40% increase), which is a potential risk. Management should investigate the cause of this inventory build-up to avoid potential cash flow problems.