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Understanding Liquidity Ratios and How to Calculate Them

Liquidity ratios are essential financial metrics used to evaluate a business's ability to meet its short-term obligations. In this blog post, we will explore two commonly used liquidity ratios: the current ratio and the liquid capital ratio (also known as the acid test ratio). We will delve into how to calculate these ratios and what they reveal about a business's financial health.

Learn more by watching the video and reading the blog post below:

Why are Liquidity Ratios Used?

Liquidity ratios serve the purpose of assessing a company's capability to fulfill its short-term financial commitments. These ratios are of particular interest to individuals or entities considering providing short-term credit to the business. By examining liquidity ratios, one can ascertain the ease with which the business can repay its debts.

The Current Ratio

The current ratio is the first liquidity ratio we will discuss. It is computed by dividing current assets by current liabilities. Current assets represent the resources that can be converted into cash within a year, while current liabilities are the obligations due within the same period. The values required to calculate the current ratio can be found on a statement of financial position (also known as a balance sheet).

To determine the current ratio, follow these steps:

  1. Locate the current assets and current liabilities on the statement of financial position.

  2. Divide the total current assets by the total current liabilities.

  3. The resulting ratio reveals the relationship between current assets and current liabilities.

If the current ratio is greater than 1, it indicates that the business has sufficient current assets to cover its short-term financial obligations. Conversely, if the ratio falls below 1, the business possesses fewer current assets than current liabilities, suggesting potential difficulties in repaying short-term obligations.

The Liquid Capital Ratio (Acid Test Ratio)

The liquid capital ratio, also known as the acid test ratio, is the second liquidity ratio we will explore. This ratio is similar to the current ratio, but it excludes inventory from the calculation of current assets. Inventory may take time to sell and might not be readily convertible to cash for settling debts. The liquid capital ratio focuses solely on cash and debtors as current assets.

To calculate the liquid capital ratio, follow these steps:

  1. Subtract the inventory value from the total current assets.

  2. Divide the result by the total current liabilities.

  3. The outcome represents the liquid capital ratio.

The liquid capital ratio provides insight into a business's ability to meet short-term financial obligations without relying on the sale of inventory. If the calculated ratio is below 1, it suggests potential liquidity issues, as the business possesses less current assets (excluding inventory) than current liabilities.

Interpreting Liquidity Ratios

Interpreting liquidity ratios involves making comparisons with industry competitors and analysing liquidity trends within the business over time. Let's interpret the liquidity ratios calculated for business Zed in the example.

For business Zed, the current ratio is calculated as 1.25 to 1, indicating that the company can meet short-term financial obligations. However, a ratio below 1 would signify liquidity problems and necessitate implementing financial management measures. Conversely, an excessively high current ratio may indicate excessive cash holdings that could be better invested to achieve a higher rate of return.

Regarding the liquid capital ratio, which measures true liquidity, business Zed's ratio is calculated as 0.39 to 1. This low ratio signifies that the business has less than half the amount of current assets (excluding inventory) to cover its current liabilities. This discrepancy between the liquid capital ratio and the current ratio reveals that a significant portion of the business's current assets is tied up in inventory.

Liquidity ratios provide valuable insights into a company's ability to meet short-term financial obligations. The current ratio and liquid capital ratio (acid test ratio) are two of the key liquidity ratios used by investors, creditors, and analysts to assess a company's short-term financial health. By calculating and analysing these ratios, stakeholders can make informed decisions regarding the company's liquidity position and its ability to fulfill its obligations.

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