Liquidity

The concept of liquidity

The concept of liquidity

• Liquidity refers to the cash and other current assets businesses have available to quickly pay bills and meet short-term financial obligations

• A business that cannot pay its debts is considered insolvent

  • If a business cannot pay its suppliers, raw materials or components may not be delivered, and production may be delayed

  • If it cannot repay an overdraft, banking facilities may be withdrawn, and its credit rating will suffer

  • Creditors may force it to stop trading and sell its assets so that the debts owed to them are repaid

• The liquidity of a business can be measured using two ratios

  • Current ratio

  • Acid test ratio

Current ratio

Current ratio

• The current ratio indicates how many £s (or other currency units) of current assets are available to cover each £1 (or other currency unit) of short-term debt

  • Its is a quick way to measure liquidity

    • The outcome is expressed as a ratio

    • All types of current asset are included in calculating this ratio

    • The result

• It is calculated using the formula

equation$$\begin{gathered} \mathrm{Current} \mathrm{ratio} = \frac{\mathrm{Current} \mathrm{assets}}{\mathrm{Current} \mathrm{liabilities}} \\ = ? :1 \end{gathered}$$

Acid test ratio

Acid test ratio

• The Acid Test Ratio (also called the Quick Ratio) is a measure of a business’s liquidity – how easily it can pay its short-term debts without relying on selling inventory (stock)

  • It is expressed as a ratio

  • It is also known as the liquid capital ratio

  • The least liquid form of current assets (inventory) is deducted so the acid test ratio provides a more realistic measure of the business'sability to meet short-term debts quickly

    • It often takes time to sell inventory so it is excluded

• The acid test is calculated using the formula

$$\begin{gathered} \mathrm{Acid} \mathrm{test} \mathrm{ratio} = \frac{ \mathrm{Current} \mathrm{assets} - \mathrm{Inventory}}{\mathrm{Current} \mathrm{liabilities}} \\ = ? : 1 \end{gathered}$$