Analysis Of Published Accounts: Depreciation (Copy)

10.2 Business Accounts And Analysis

10.2.1 Liquidity Ratios

The Meaning And Importance Of Liquidity

• Definition of liquidity
  • Liquidity refers to the ability of a business to meet its short-term obligations (usually within 12 months) as they fall due, using its current assets.
  • It reflects how easily assets can be converted into cash to pay trade payables, wages, expenses, and short-term loans.
• Key points
  • A business with high sales and profits may still fail if it lacks liquidity to pay day-to-day bills.
  • Liquidity is not the same as profitability. A profitable business can collapse if it cannot meet immediate debts.
  • Cash and cash equivalents (e.g., bank balances) are the most liquid assets. Inventories are the least liquid, as they must be sold first.
• Importance of liquidity
  • Survival: Businesses must pay wages, suppliers, and bills regularly. Without liquidity, operations may stop.
  • Supplier confidence: Suppliers are more willing to provide trade credit if the business has strong liquidity.
  • Financial planning: Liquidity ratios help managers identify cash shortages in advance.
  • Investor confidence: Shareholders and banks review liquidity ratios before investing or lending.
  • Flexibility: High liquidity allows firms to respond quickly to opportunities or emergencies.
  • Avoidance of insolvency: Poor liquidity may lead to bankruptcy even if the business is making profits.
• Example
  • A business has a net profit of $100,000 but all revenue is tied up in receivables. If it cannot pay rent or wages on time, it faces insolvency despite being profitable.

Current Ratio: Calculation And Interpretation

• Definition
  • The current ratio measures the relationship between current assets and current liabilities.
  • Formula:
    • Current Ratio = Current Assets ÷ Current Liabilities
• Interpretation
  • Measures the firm’s ability to cover short-term debts using all current assets (cash, receivables, inventories).
  • A ratio of 2:1 is traditionally considered ideal (two dollars of current assets for every one dollar of current liabilities).
  • Ratio too low (<1.0): business may struggle to pay debts, risk of insolvency.
  • Ratio too high (>2.5): business may be holding excessive inventories or cash, showing inefficient use of resources.
• Example
  • Current assets = $200,000; current liabilities = $100,000.
  • Current ratio = 200,000 ÷ 100,000 = 2:1 (healthy liquidity).
  • If current ratio = 0.8:1, the business cannot cover its debts, showing liquidity problems.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Business Full Scale Course

Acid Test Ratio: Calculation And Interpretation

• Definition
  • Also known as the liquid ratio or quick ratio.
  • A more stringent test of liquidity because it excludes inventories, which may take time to sell.
  • Formula:
    • Acid Test Ratio = (Current Assets − Inventories) ÷ Current Liabilities
• Interpretation
  • Indicates the ability of a business to pay short-term debts without relying on selling inventories.
  • An acid test ratio of 1:1 is considered satisfactory.
  • If <1:1 → the business may have liquidity problems (not enough quick assets to pay debts).
  • If >>1:1 → too much cash is idle, showing inefficiency.
• Example
  • Current assets = $200,000; inventories = $80,000; current liabilities = $100,000.
  • Acid test ratio = (200,000 − 80,000) ÷ 100,000 = 120,000 ÷ 100,000 = 1.2:1 (healthy).
  • If the acid test ratio = 0.6:1, the firm cannot cover short-term debts without selling inventories, which may be risky.
• Comparison with current ratio
  • Current ratio may show good liquidity even if most assets are inventories.
  • Acid test provides a more accurate reflection of short-term financial health.
  • Example: A supermarket with high stock turnover may operate with an acid test below 1.0 and still remain liquid because goods sell quickly.

Methods Of Improving Liquidity

• Increase current assets
  • Improve cash collection from debtors by offering discounts for early payment or stricter credit control.
  • Reduce inventories by using Just-in-Time (JIT) or better inventory management.
  • Increase cash reserves by selling unused assets.
• Reduce current liabilities
  • Pay off short-term debts quickly to reduce pressure on liquidity.
  • Negotiate longer credit terms with suppliers.
  • Refinance short-term loans into long-term loans to reduce immediate obligations.
• Increase revenue
  • Increase sales through promotions, new products, or entering new markets.
  • Example: A retailer could run seasonal sales campaigns to boost cash inflow.
• Cost control
  • Reduce unnecessary expenses to keep more cash within the business.
  • Example: Cutting energy costs or outsourcing non-core activities.
• Better cash flow management
  • Prepare cash flow forecasts to predict shortages.
  • Avoid tying up cash in excessive fixed assets or non-urgent investments.
• Equity finance
  • Raise additional capital by issuing shares (for limited companies).
  • This increases cash reserves without creating more short-term liabilities.
• Example
  • A business with a current ratio of 0.9:1 could improve liquidity by selling excess stock and negotiating 60-day credit terms with suppliers.

Links Between Liquidity And Other Aspects Of Business

• Profitability and liquidity
  • A profitable business may still face liquidity problems if cash is not collected quickly.
  • Example: A construction company may show high profits but face cash shortages due to late payments.
• Inventory management
  • Inventory is included in the current ratio but excluded from the acid test.
  • Businesses with slow-moving inventory may face liquidity issues.
• Credit control
  • Granting long credit terms increases sales but reduces liquidity.
  • Stricter credit terms improve liquidity but may reduce sales.
• Finance decisions
  • A firm with poor liquidity may need to raise additional finance.
  • High liquidity may reduce the need for external borrowing.
• Operational strategy
  • Operations such as JIT help reduce inventory, improving liquidity.
  • Efficient production reduces cash tied up in stock.

Diagram – Liquidity Ratios

Liquidity Ratios
----------------------------
Current Ratio = Current Assets ÷ Current Liabilities
Acid Test = (Current Assets − Inventories) ÷ Current Liabilities

Example:
Current Assets = 200,000
Inventories = 80,000
Current Liabilities = 100,000

Current Ratio = 200,000 ÷ 100,000 = 2:1
Acid Test = (200,000 − 80,000) ÷ 100,000 = 1.2:1

Key Insights

• Liquidity measures short-term financial health, not profitability.
• Current ratio shows ability to pay debts with all current assets. Ideal: around 2:1.
• Acid test ratio shows ability to pay debts without selling stock. Ideal: around 1:1.
• Too low ratios → risk of insolvency. Too high ratios → inefficient use of resources.
• Liquidity can be improved through better cash collection, reducing stock, controlling costs, negotiating better credit terms, or raising additional finance.
• Managers, investors, and banks use liquidity ratios to assess financial risk and sustainability.

Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change A2 Level Business Full Scale Course