Liquidity ratios
Liquidity ratios calculate the organisation’s ability to turn into cash in order to pay debts.
Current ratio
Current ratio or the working capital ratio demonstrates the firms ability to meet its short-term .
An ideal ratio of 2:1 is generally agreed. If the ratio is higher, 4:1 it could mean that the firm is inefficient and has too much money tied up in stock. On the other hand, a lower ratio value of 1:1 would mean that it may not be able to meet its debts quickly.
The formula is: current assets: current liabilities
Ways of improving this is to:
- increase current assets
- if ratio is too high you can sell non-current assets
- decrease current liabilities for example, reducing trade credit terms
Acid test ratio
Acid test ratio is a more severe test of a firm’s capabilities to meet its debts. The formula is the same as the but with the added problem of writing off all stock. This is because it assumes that stock:
- may be perishable
- may go out of date
- may go out of fashion or become obsolete
In other words, the firm may be left with stock it cannot sell. An ideal value of 1:1 is generally accepted.
The formula is: (current assets – closing inventory): current liabilities
