# Liquidity Ratios

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• Created by: Emma Rudd
• Created on: 25-03-08 16:29

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BMA
Liquidity Ratios
These rations allow managers and other interested parties to monitor a business's cash position. Even
profitable businesses can experience problems with liquidity and may be unable to pay their bills as
they fall due. Liquidity ratios measure the liquid assets held by a firm(cash and other assets such as
debtors that are easily convertible into cash). The value of these assets is then compared with the
shortterm debts or liabilities the business will incur. In this way stakeholders may evaluate whether
the business's performance may be harmed as a result of liquid problems.
1. Current Ratio
This measures the ability of a business to meet its liabilities or debts over the next year or so. The
formula to calculate this ratio is
Current Ratio = Current Assets
Current Liabilities
The current ratio is expresses in the form of a ratio. For example 2:1 would mean that the firm in
question possessed £2 of current assets (cash, debtors & stock) for each £1 of current liability
(creditors, taxation & proposed dividends). Therefore in these circumstances it is clear that the
business should be able to pay their short term bills.
Using this Ratio
For years holding current assets twice the value of current liabilities was recommended. This is
no longer accepted partly due to the use of computers in stock control and the wide spread use
of just in time systems of production.
The `normal' figure for the ration varies according to the type of business and the state of the
market.
Firms with high current ration values (3:1 for example) are not necessarily managing their
finances effectively. It may be that they are holding to much cash and not investing in fixed
assets to generate more income. Alternatively they may have large holdings of stock, some of
which may be obsolete.
Firms improve the current ratio by raising more cash through the sale of fixed assets or the
negotiation of long term loans. (Rising more cash through short term borrowing will increase
current liabilities, having little effect on the current ratio.)
2. Acid Test Ratio
This ratio measures the very short term liquidity of a business. The acid test ratio compares a
business's current liabilities with its liquid assets (i.e. current assets ­ stock) this can provide a
more accurate indicator of liquidity than the current ration as stock can take time to sell. The acid
test ratio measures the ability of a firm to pay its bills over a period of 2 or 3 months without
requiring the sale of stock.
The formula for the Acid Test Ratio is
Acid Test Ratio = (Current Assets ­ Stock)
Current Liabilities
The Acid Test ratio is also expressed in the form for a ration (for example 2:1).
Using this Ratio
Conventionally a `normal' figure for the acid test ratio was thought to be 1:1 giving a balance of
liquid assets and current liabilities. However by the Millennium, a number of businesses were
operating successfully with acid test figures nearer 0.7 : 1
The value of the Acid Teat ratio considered acceptable will vary according to the type of
business. The ideal ratio figure is 0.8: 1.
Firms should not operate over long periods with high acid test ratios as holding assets in the
form of cash is not profitable and does not represent an effective use of resources.
As with the current ratio, the Acid Test can be improved by selling fixed assets or agreeing
longterm borrowing.
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