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A LevelBusinessCambridge (CIE)Revision Notes5. Finance & AccountingAnalysing Published Accounts (A Level)Liquidity Ratios

Liquidity Ratios (Cambridge (CIE) A Level Business): Revision Note

Exam code: 9609

Lisa Eades

Written by: Lisa Eades

Reviewed by: Steve Vorster

Updated on

The meaning and importance of liquidity

  • Liquidity is the ability of a business to pay back its short-term debts, e.g. its suppliers

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    • If it cannot repay an overdraft, banking facilities may be withdrawn, and its credit rating will suffer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

  • The Current Ratio is a quick way to measure liquidity and the outcome is expressed as a ratio

  • All forms of current asset are considered in this ratio

  • The current ratio is an effective liquidity measure for businesses that hold little stock

  • The result indicates how well current assets can cover short-term debt

  • It is calculated using the formula

Current space ratio space equals space fraction numerator space Current space assets over denominator Current space liabilities end fraction equals space space space space space ? space space space space space space colon space space space space space 1

Worked Example

Packer Sports Ltd has current assets of $15,545, current liabilities of $5,060 and an inventory figure of $8,250.

Calculate Packer Sports Ltd’s current ratio.

[2]

Step 1: Substitute the values into the equation

   equals space fraction numerator $ 15 comma 545 space over denominator $ 5 comma 060 end fraction equals space space space space 3.07 space colon space 1       (2)

  • In this example, Packer Sports Ltd has $3.07 of current assets to cover each $1 of short-term debt

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 inventory

    • 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 businesses ability to meet short-term debts quickly

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

    • It is calculated using the formula

      Acid space test space ratio space equals space fraction numerator space Current space assets space minus space Inventory over denominator Current space liabilities end fraction equals space space space space space ? space space space space space space colon space space space space space 1

Worked Example

Packer Sports Ltd has current assets of $15,545, current liabilities of $5,060 and an inventory figure of $8,250.

Calculate Packer Sports Ltd’s acid test ratio.

[3]

Step 1: Subtract inventory from current assets 

$ 15 comma 545 space minus space $ 8 comma 250 equals space $ 7 comma 295      (1)

Step 1: Substitute the values into the equation

Acid space test space ratio space equals space fraction numerator space Current space assets space minus space Inventory over denominator Current space liabilities end fraction equals space fraction numerator space $ 7 comma 295 over denominator $ 5 comma 060 end fraction equals space 1.44(1)

Step 2: Express the outcome as a ratio

equals space 1.44 space colon space 1   (1)
  

  • In this example, Packer Sports Ltd has $1.44 of the most liquid current assets to cover each $1 of short-term debt

Methods of improving liquidity

  • A business will often need to take quick, decisive steps to improve their liquidity

Ways to improve liquidity

Flowchart titled "Ways to Improve Liquidity" with strategies: reduce credit period, manage better, extend supplier credit, overdrafts, new capital, sell assets.
Liquidity can be improved in a number of ways 

Methods to improve liquidity

Method

Explanation

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

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 inventory

  • 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

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

Sell assets and lease fixed assets instead (e.g. sale & 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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    Author
    Reviewer
    Lisa Eades

    Author: Lisa Eades

    Expertise: Business Content Creator

    Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.

    Steve Vorster

    Reviewer: Steve Vorster

    Expertise: Economics & Business Subject Lead

    Steve has taught A Level, GCSE, IGCSE Business and Economics - as well as IBDP Economics and Business Management. He is an IBDP Examiner and IGCSE textbook author. His students regularly achieve 90-100% in their final exams. Steve has been the Assistant Head of Sixth Form for a school in Devon, and Head of Economics at the world's largest International school in Singapore. He loves to create resources which speed up student learning and are easily accessible by all.