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Using Liquidity Ratios to Analyse Performance

Exam code: 7115
Written by: Ashika|Reviewed by: Caroline Carroll|Updated 2 July 2026

Liquidity ratios

Liquidity ratios

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

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

    • Current ratio

    • Acid test ratio

The current ratio

  • The Current Ratio 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 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

    • It is calculated using the formula

Current ratio = Current assetsCurrent liabilities  = ? :1{"fontFamily":"Times New Roman","fontSize":"18","autoformat":true,"toolbar":""}

The acid test ratio

  • The acid test ratio is a precise and realistic way to measure liquidity, especially for businesses that hold large amounts of stock

    • It is expressed as a ratio

    • It is also known as the liquid capital ratio

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

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

    • The Acid Test is calculated using the formula

Acid test ratio =  Current assets - stockCurrent liabilities=     ?      :     1{"fontFamily":"Times New Roman","fontSize":"18","autoformat":true,"toolbar":""}

Improving liquidity ratios

Improving liquidity ratios

  • The best way to improve liquidity is to manage the business better

    • Use cash flow forecasts to identify potential cash flow issues before they arise and take appropriate action

    • Budget effectively and consider adopting zero budgeting to carefully control spending

    • Set clear financial objectives and look for ways to reduce costs and increase income wherever possible

Methods to improve liquidity

Method

Explanation

Reduce the credit period offered to customers

  • Collecting money owed from customers more quickly will increase the level of current assets in the business

  • Customers may move to competing businesses that offer better credit terms

Ask suppliers for an extended repayment period, e.g an extension from 60 to 90 days

  • Current liabilities will not be reduced

  • The business can use cash it would have paid to suppliers for other purposes

  • Suppliers may be unwilling to extend credit terms

Make use of overdraft facilities or short-term loans

  • Current liabilities will increase

  • The business can spend more money than it has in its bank account

  • Banks may be reluctant to lend to businesses with cash-flow problems

Sell off excess stock

  • Less liquid current assets will be reduced and converted into more liquid forms of current asset (e.g. cash)

  • Storage and security costs may also be reduced

  • Stock may need to be sold at a low price to attract sales

Sell assets and lease fixed assets instead (e.g. sale and leaseback)

  • Both current assets and current liabilities will increase

  • The business will continue to have the use of assets but must make regular payments to the leasing company

Introduce new capital and reduce drawings out of the business

  • Current assets will be increased

  • New capital may be introduced by the owner or from additional investors

    • This may result in the dilution of control of the business

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