IGCSE Liquidity Analysis
In this lesson, we will learn how to calculate and interpret the current ratio and liquid ratio; and compare the liquidity performance across different years of the business, and with other businesses.
Related Lessons:
Purpose of Liquidity Management
Liquidity refers to the ability of a business in repaying its current debts and funding its daily business operation with its current assets. Therefore, it is important for the business as insufficient liquidity may lead to:
- Inability to repay debts on time thereby losing cash discounts
- Inability to purchase goods on credit thus losing bulk discount
- Loss of trust by staffs and customers
- Lost investment opportunities
Calculating & Interpreting Current & Liquid Ratios
Current Ratio (or Working Capital Ratio)
This ratio measures the ability of a business to pay its current debts with its current assets, ideally at a ratio of 2:1.
To calculate, we take Current Assets divided by Current Liabilities. This gives us the amount of current asset to repay $1 of current debt.
Current Assets / Current Liabilities = x:1
A current ratio of 2:1 means that the business has $2 of current asset to repay every $1 of its current liability. The business is able to repay its current debt in full and still have excess current asset to meet investment opportunities.
A business is considered not liquid when it has insufficient current asset to repay its current debt. That is, a current ratio with current asset falling below 1, example, 0.9:1.
Liquid Ratio (or Quick or Acid Test Ratio)
This ratio measures the ability of a business to pay its short-term debts using its liquid (or immediate) assets, ideally at a ratio of 1:1.
To calculate, we take Current Assets minus Inventory and divide it by Current Liabilities. This gives us the amount of liquid asset to repay $1 of current debt.
Current Assets – Inventory / Current Liabilities = x:1
A liquid ratio of 1:1 means that the business has $1 of liquid asset to repay every $1 of current debt. The business can fully repay its current debts without keeping too much cash idle.
The business is considered not liquid when it has insufficient liquid assets, that is, a liquid ratio that falls below 1 (example 0.9:1).
Possible Problems Due to Shortage of Funds
- Unable to repay debts when due
- Unable to enjoy cash discounts
- Unable to purchase goods on credit
- Difficulty in retaining staff
- Lose the trust of customers
- Unable to take advantage of business opportunities as they arise
Possible Ways to Improve Liquidity
- Owner may inject additional capital
- Restructure or take up a loan
- Sell unwanted non-current assets
- Invite investors