ZIMSEC O Level Business Studies Notes: Business Finance and Accounting: Ratio Analysis:Liquidity ratios

  • Liquidity is a measure of how well a business can meet its short term obligations as and when they fall due
  • It is usually expressed in terms of how well the entity in question can convert its assets into cash
  • Short term obligations include amounts owed to creditors, bank overdraft, interest on debentures
  • Short term obligations are also known as current liabilities
  • These are amounts owing that have to be settled by the business within a period of one year or less
  • In accounting and finance liquidity is usually measured by how well current assets can meet current liabilities
  • Current assets comprise cash and other items that can be quickly converted into cash to pay creditors when they come calling
  • Liquidity ratios are therefore used to express the level of risk that a business will be able or not able to pay its creditors when they demand payment
  • There are two main ratios used to measure liquidity:
    1. Current Asset Ratio
    2. Acid Test Ratio/Quick Asset Ratio
  • Both make use of the concept of working capital and compare current assets to current liabilities

Current Asset Ratio

  • The ratio is calculated using the formula:
  • \mathrm{Current \quad Ratio = \dfrac{Current\quad Assets}{Current\quad Liabilities}}
  • For example let us say we have current assets of $3 000 and current liabilities of $ 1 500
  • The ratio would be calculated as follows:
  • \mathrm{\dfrac{3000}{1500}}
  • 2
  • This means for every $1 in fixed there is $2 in current assets
  • In other terms there is twice as many current assets as there are current liabilities
  • The ratio is expressed as a number in decimal terms
  • Generally the current asset should be between 1.5 and 2
  • If it is any lower than this it means there is a real chance the business will face difficulties when trying to pay its creditors
  • If it is higher than this it means a lot of resources are tied up in the form of current assets

Quick Asset Ratio/Acid Test Ratio

  • It is a more stringent/rigorous ratio
  • It is based on the realization that it might not be so easy to convert the item of stock into cash when creditors come knocking and the business has to pay
  • In such cases a business might even have to sell its stocks on discount in order to quickly raise cash
  • Including stock in determining liquidity can result in inaccuracies
  • The ratio recognizes this fact by deducting the asset of stock from current assets
  • The formula for the acid test ratio is:
  • \mathrm{Acid \quad Test \quad Ratio = \dfrac{Current\quad Assets-Stock}{Current\quad Liabilities}}
  • For example if the above mentioned business has stock valued at $ 1 500
  • Then the acid test ratio would be:
  • \mathrm{\dfrac{3000-1500}{1500}}
  • 1
  • As a general rule a ratio of 1 is considered ideal
  • A lower ratio would mean that the business might be unable to meet its short term obligations
  • A higher ratio means money is tied up in the form of current assets which are unprofitable

To access more topics go to the O Level Business Notes

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