Liquidity Ratios (Cambridge (CIE) IGCSE Accounting): Revision Note

What are liquidity ratios?

• Liquidity ratios are ways to measure how quickly a business can convert assets into cash

  • They compare the current assets to the current liabilities

• The liquidity ratios are:

  • Current (working capital) ratio

  • Acid test (liquid) ratio

Current (working capital) ratio

What is the current (working capital) ratio?

• Working capital is current assets minus current liabilities

• A ratio close to 2:1 is generally good

  • If it is less than 1:1 then the business does not have enough current assets to cover its current liabilities

  • If it is too high then the business could have too much inventory or trade receivables

    • They need to improve their inventory control

    • They need to encourage credit customers to pay faster

Acid test (liquid) ratio

What is the acid test (liquid) ratio?

• This ratio is also known as the quick ratio

• It measures how well current liabilities are covered by the more liquid forms of current assets

  • The most liquid forms are cash and trade receivables

• A ratio close to 1:1 is generally good

  • If it is above 1:1 then the business has enough liquid assets to cover its short-term debts even if the inventory cannot be sold

  • If it is too high then the business could be owed too much by trade receivables

    • They need to encourage credit customers to pay faster