The Current Ratio provides a broad view of liquidity by comparing all current assets to all current liabilities. It indicates how many currency units of assets are available to cover every 1 unit of debt.
Current Ratio Formula:
The Acid Test Ratio (or Quick Ratio) is a more conservative measure that excludes inventory from current assets. This is because inventory cannot always be sold quickly or at its full value during a financial squeeze.
Acid Test Ratio Formula:
Asset Management: Selling off excess or slow-moving inventory converts 'stuck' value into cash. Alternatively, using sale and leaseback allows a business to sell a fixed asset (like a building) for a cash injection while continuing to use it via a lease.
Credit Control: Reducing the credit period offered to customers (e.g., from 60 days to 30 days) speeds up cash inflows. Conversely, negotiating longer payment terms with suppliers keeps cash in the business for longer.
External Financing: Arranging an overdraft or short-term loan provides immediate liquidity, though it increases current liabilities and incurs interest costs.
Check the Units: Always ensure you are working with consistent units (e.g., thousands vs. millions). A common error is mixing raw figures with abbreviated ones.
The Ratio Format: Always express the final answer as a ratio (e.g., ). Simply writing '' may lose marks for formatting.
Interpret, Don't Just Calculate: If asked to evaluate, explain what the number means. A ratio of means the business has only for every it owes, indicating a high risk of insolvency.
Seasonality: Remember that liquidity fluctuates. A business might have low liquidity after a major stock purchase but high liquidity after a peak sales period like a holiday season.
