G1 Liquidity Ratios
Liquidity is a measure of how well a business can pay its short-term debts. Failure to meet financial obligations can have negative implications on the operations and survival of the business. When assessing the liquidity of a business, it is important to analyse the availability of assets that can be easily converted to cash, alongside current liabilities that need to be paid in the short term. Maintaining a balance between current assets and current liabilities is crucial for ensuring the business has sufficient liquidity to cover its short-term debts.
| 2023 | 2022 | 2021 | 2020 | 2019 | |
|---|---|---|---|---|---|
| Current assets | 120,000 | 140,000 | 135,000 | 150,000 | 160,000 |
| Inventory | 30,000 | 20,000 | 25,000 | 30,000 | 40,000 |
| Current liabilities | 100,000 | 70,000 | 90,000 | 65,000 | 90,000 |
Current (liquid) assets are the assets that a business expects to convert into cash in the short term, usually within the next 12 months. These are the items that a business can use to pay their short term debts and therefore contribute to the liquidity of the business. Current assets include cash, debtors and stock (inventory).
Current liabilities are the debts that a business expects to pay in the short term. These include creditors (suppliers) and short term loans. If a business does not meet these financial obligations, they are at risk of suppliers refusing to deliver or lenders taking legal action.
The Current Ratio
The current ratio compares current assets to current liabilities which is essentially comparing the money that is most readily available to the short term debts. It is measured using this formula
current ratio = current assets/current liabilities
For The Coffee Hub in 2023, current ratio = 120,000/100,000 = 1.2:1. This means that they have £1.20 in current assets for every £1 of current liabilities.
| 2023 | 2022 | 2021 | 2020 | 2019 | |
|---|---|---|---|---|---|
| Current ratio | 1.2 | 2 | 1.5 | 2.3 | 1.8 |
| Acid test ratio | 1.2 | 1.5 | 0.9 | 1.3 | 0.7 |
A ratio of between 1.5:1 and 2:1 is most desirable. A ratio of 1.5: 1 means that a business has £1.50 of current assets for every £1 of current liabilities. This means that they should have enough liquid assets to cover their current debts.
A current ratio of below 1.5:1 may mean that the business may struggle to pay their short term debts. A current ratio of above 2:1 may mean they have more money tied up in current assets than they need. This could mean that they are wasting money that could be invested in the growth of the business.
The Liquid Capital Ratio (Acid Test Ratio)
The liquid capital ratio measures how well a business can pay their short term debts with their liquid assets but does not count inventory (stock) as a liquid asset. This is because inventory may be difficult to sell and it may take a while to collect payment. It is calculated using the formula
Liquid capital ratio = (current assets – inventory)/current liabilities.
For The Coffee Hub in 2023, liquid capital ratio = (120,000 - 30,000) / 100,000 = 0.9:1. This means that if they do not sell their inventory, they only have £0.90 of current assets for every £1 of current liabilities.
A healthy range would be considered as 1.1 - 2:1, wth anything above 1:1 generally being acceptable. This would indicate that a business has enough liquid assets to cover their current financial obligations without needing to sell their stock. A liquid capital ratio of 1:1 means that a business has £1 of current assets for every £1 of current liabilities without having to sell their inventory.
A liquid capital ratio of below 1:1 would mean that if a business did not sell their inventory, they would not be able to cover their current financial obligations. A liquid capital ratio of above 2:1 would mean that a business has too much money tied up in liquid assets that they could invest in growth.