Revise Liquidity ratios for Cambridge 9609 (10.2.1)

Liquidity is a measure of a business's ability to meet its short-term debts and financial obligations as they fall due, typically within the next 12 months. It essentially assesses the availability of liquid assets (cash or assets that can be quickly converted into cash) to pay off current liabilities. A business that is illiquid faces a significant risk of insolvency, even if it is profitable on paper. This is because profit is an accounting concept, whereas cash is required for day-to-day survival – paying suppliers, employees, and overheads. Maintaining adequate liquidity is crucial for building confidence with suppliers, who may be willing to offer favourable credit terms, and with lenders, who will assess liquidity before approving loans. It provides a vital safety buffer against unexpected expenses or a sudden drop in revenue.

The current ratio is a primary measure of liquidity, calculated using the formula: Current Assets / Current Liabilities. The result is expressed as a ratio, for example, 2:1. This indicates that for every £1 of current liabilities, the business has £2 of current assets to cover them. While there is no single 'perfect' ratio, a generally accepted guideline for many industries is between 1.5:1 and 2:1. A ratio below 1:1 is a cause for concern as it suggests the business may not have enough liquid assets to cover its short-term debts. Conversely, a very high ratio (e.g., 4:1) might not be ideal either, as it could indicate that too much capital is tied up in unproductive assets like excess inventories or large cash balances, which could be invested for a better return.

The acid test ratio, also known as the quick ratio, provides a more stringent and immediate assessment of a firm's liquidity. It is calculated by the formula: (Current Assets - Inventories) / Current Liabilities. The key difference is the exclusion of inventories (stock) from current assets. This is because inventories are often the least liquid of all current assets; they cannot be converted into cash instantly and may have to be sold at a discount to be liquidated quickly. For businesses with slow-moving or specialised inventories, the acid test ratio is a much more realistic indicator of their ability to meet immediate obligations. An ideal result is often considered to be around 1:1, signifying that the business has £1 of liquid assets for every £1 of current liabilities, without needing to sell any inventory.

Interpreting liquidity ratios requires context. A single ratio is a snapshot in time and offers limited insight. For meaningful analysis, ratios should be compared over several years to identify trends (trend analysis) and benchmarked against key competitors or the industry average. For example, a supermarket may operate successfully with a low current ratio due to high inventory turnover and cash sales, whereas a luxury car dealership would require a much higher ratio. If liquidity is poor, a business can take several actions. Short-term strategies include arranging an overdraft or delaying payments to suppliers. More sustainable, long-term improvements involve selling unproductive non-current assets, using sale and leaseback for property, or implementing Just-in-Time (JIT) inventory management to reduce capital tied up in stock. These actions can improve cash flow and strengthen the balance sheet.

Current ratio = $\frac{\text{Current assets}}{\text{Current liabilities}}$

Acid test = $\frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}$