Cambridge IGCSE Accounting(0452)/O Level Principles of Accounts(7110) Notes: Introduction to Liquidity Ratios: Current Asset Ratio

  • As pointed out in the introduction
  • One of the liquidity ratios that you need to be familiar with is the Current Asset Ratio
  • Like all liquidity ratios it measures how well a business will be able to settle its short term obligations as and when they fall due
  • It specifically measures how well current assets cover current liabilities
  • 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
  • One drawback of the ratio is that it incorporates the inventory/stock in the formula
  • In the real world it might be difficult to quickly sale stock/inventory in order to settle current liabilities when creditors come calling
  • A more stringent measure the excludes stock might be needed in such instances
  • This ratio is known as the Acid Test Ratio

NB Click on the link above to learn more about the Acid Test Ratio

To access more topics go to the Principles of Accounting Notes.