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Liquidity ratios
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Liquidity ratios check whether a business can pay its bills in the short term.
The ratios
Current (working capital) ratio = current assets ÷ current liabilities
Liquid (acid test) ratio = (current assets − inventory) ÷ current liabilities
Both are written as a ratio, such as 1.8 : 1.
Liquid (acid test) ratio = (current assets − inventory) ÷ current liabilities
Both are written as a ratio, such as 1.8 : 1.
Why leave out inventory?
Inventory is the least liquid current asset: it must be sold, and perhaps the customer must then pay, before it becomes cash.
So the liquid ratio is a stricter test of whether debts can be paid immediately.
So the liquid ratio is a stricter test of whether debts can be paid immediately.
Interpreting
A current ratio below 1 : 1 means current liabilities are bigger than current assets: a warning sign. Around 1.5 to 2 : 1 is often seen as comfortable.
A liquid ratio below 1 : 1 may mean difficulty paying debts quickly.
Very high ratios may mean too much cash or inventory sitting idle. Compare with past years and similar businesses.
A liquid ratio below 1 : 1 may mean difficulty paying debts quickly.
Very high ratios may mean too much cash or inventory sitting idle. Compare with past years and similar businesses.
Current assets £36 000, including inventory £15 000. Current liabilities £14 000. Find both ratios.
- Current = 36 000 ÷ 14 000 = 2.57
- Liquid = (36 000 − 15 000) ÷ 14 000 = 1.5
Answer: 2.57 : 1 and 1.5 : 1
Current ratio = current assets ÷ current liabilities. Liquid ratio = (current assets − inventory) ÷ current liabilities. Below 1 : 1 is a warning sign. Compare with past years and similar firms.
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