0264 · 5.5.2Liquidity

Liquidity and current assets

0:00A bicycle shop can have valuable products on display and customers waiting to collect their purchases. Its supplier still expects payment when the bill becomes due. The owner needs money available at the right time to keep trading. By the end of this video, you will understand how two liquidity ratios help judge that ability. Current liabilities are debts repayable within one year. Liquidity is the ability of a business to pay its short-term debts when they are due.

0:23Those debts include amounts owed to suppliers and short-term borrowing. A business with sufficient money available can meet these commitments and maintain its suppliers’ confidence. The central issue is the connection between resources available soon and debts that require payment soon. A building may be valuable, but selling it takes time and could interrupt trading. Money already available can settle a bill immediately. Liquidity therefore depends on how readily the business can obtain money to meet its commitments.

0:50Current assets are assets expected to be converted into cash or used up within twelve months. Cash is the money a business holds as notes and coins and in its bank account. Trade receivables are amounts owed to a business by customers who bought on credit. These customers receive their purchases now and pay later. Inventory is the goods and materials a business holds, for use in production or for sale.

1:11Trade payables are amounts a business owes suppliers for purchases made on credit. Inventory belongs among current assets, while trade payables are included in current liabilities. These categories provide the figures needed for our calculations. A statement of financial position shows the value of a business’s assets, liabilities and owners’ capital on a particular date. We use its current asset and current liability figures to assess liquidity. Both ratios compare resources with short-term debts, but they treat inventory differently.

1:40That difference helps reveal how much the business depends on selling its goods.

Calculating the current ratio

1:44The current ratio compares current assets with current liabilities. Current ratio equals current assets divided by current liabilities. Division shows the amount of current assets available for each dollar of short-term debts. Because both amounts use the same currency, the result is expressed as a number or a ratio to one. Bramble Lane sells bicycles and replacement parts. At the end of its first year, current assets total sixty thousand dollars and current liabilities total forty thousand dollars.

2:13Inventory accounts for twenty-four thousand dollars of those current assets. We will use these figures to calculate both ratios and interpret the difference. For the current ratio, start with the full value of current assets. Sixty thousand dollars divided by forty thousand dollars gives one point five. Expressed as a ratio, the answer is one point five to one. For every dollar of current liabilities, Bramble Lane has one dollar and fifty cents of current assets.

2:36This provides some cover because the value of current assets exceeds short-term debts. However, the composition of those assets matters. Part of the total consists of bicycles and replacement parts waiting to be sold. The business must find customers and receive payment before that inventory can help settle its bills.

Acid test ratio and interpretation

2:53The acid test ratio compares current assets excluding inventory with current liabilities. Acid test ratio equals current assets minus inventory, divided by current liabilities. Inventory is left out because it is usually the hardest current asset to turn into cash quickly. This gives a stricter assessment of the resources available to meet short-term debts. For Bramble Lane, begin with current assets of sixty thousand dollars. Sixty thousand dollars minus twenty-four thousand dollars gives thirty-six thousand dollars.

3:21Thirty-six thousand dollars divided by forty thousand dollars gives zero point nine, so the acid test ratio is zero point nine to one. There are ninety cents of current assets excluding inventory for each dollar of current liabilities. On these figures, the business relies on selling some inventory to cover all its short-term debts. This creates risk if customers buy slowly or suppliers require payment soon. The current ratio and acid test ratio together reveal that dependence.

3:47A current ratio below one means current assets cannot cover current liabilities at their recorded values. An acid test ratio below one shows reliance on selling inventory to cover those debts. Actual payment dates still matter because customers and suppliers may have different credit periods. These ratios flag potential pressure, while payment timing helps explain its seriousness. For the current ratio, a value between one point five to one and two to one is often used as a typical guide.

4:13One to one is a typical guide for the acid test ratio. At that level, current assets excluding inventory equal current liabilities. Appropriate levels depend on the business and how quickly it receives money. A food retailer collecting cash daily may manage with a lower ratio than a manufacturer waiting for customers to pay. A very high current ratio also deserves attention. Idle cash earns little and could be invested in the business instead.

4:38Excessive inventory ties up money and may become damaged or out of date. Managers need enough resources to meet debts alongside productive use of funds. Understanding the assets behind the ratio is therefore essential when judging the business’s position.

Comparing liquidity over time

4:51Comparing years helps show how liquidity changes. At the end of the following year, Bramble Lane has current assets of seventy-five thousand dollars. Inventory is twenty-one thousand dollars, and current liabilities are thirty thousand dollars. We must calculate both ratios again before judging the change. Using the current ratio formula, divide seventy-five thousand dollars by thirty thousand dollars. The result is two point five, or two point five to one.

5:16Bramble Lane now has two dollars and fifty cents of current assets for each dollar of current liabilities. This provides greater cover than the first year’s one point five to one. For the stricter measure, seventy-five thousand dollars minus twenty-one thousand dollars gives fifty-four thousand dollars. Fifty-four thousand dollars divided by thirty thousand dollars gives one point eight. Expressed as a ratio, the acid test result is one point eight to one.

5:39It has increased from zero point nine to one in the first year. Both ratios have risen, so the figures indicate improved liquidity. Current assets excluding inventory now exceed current liabilities. The business has stronger cover for its short-term debts and less dependence on future inventory sales. A current ratio of two point five to one is above the typical guide, so the owner could check whether some cash is idle and invest it.

6:02Managers should still check when customers will pay and when suppliers require their money. If liquidity is under pressure, collecting trade receivables sooner brings money into the business earlier. Selling slow-moving inventory for cash releases funds tied up in unsold goods. Negotiating longer payment periods with suppliers can give the business more time to obtain money. Each action addresses the practical challenge of meeting debts when they become due. Keep the calculation process precise by using current liabilities as the denominator in both formulas.

6:30For the acid test ratio, remove inventory before dividing. Present the final answer as a number or a ratio to one. Its interpretation should describe the resources available for each dollar of short-term debts. Revenue is the income a business receives from selling goods or services. Profit is total revenue minus total costs. Sales made on credit can increase profit before customers pay. Liquidity focuses on the ability to meet short-term debts, so profitable trading can still involve payment pressure.

6:59In either examination paper, figures may appear in information about a particular business. Calculate means work out from given facts, figures or information. Show the formula, substitute the relevant amounts and give the answer clearly. Explain means set out purposes or reasons, say why and how, supported with relevant evidence. Bramble Lane has an acid test ratio of zero point nine to one in its first year. Its current assets excluding inventory are below its current liabilities.

7:25The business therefore relies on selling some inventory to cover all its short-term debts. Slow sales could delay payments to suppliers, so they face a risk of receiving their money late. Remember the central definition: liquidity is the ability of a business to pay its short-term debts when they are due. Current ratio equals current assets divided by current liabilities. For the stricter measure, acid test ratio equals current assets minus inventory, divided by current liabilities.

7:51Interpret both using the business’s circumstances, payment timing and changes over time.