Financial Analysis

Liquidity Ratios

Summary of formulas

Current ratio

Compares current assets to current liabilities — measures the ability to pay short-term debts.

• Above 1:1 — can pay all short-term debts and retain working capital
• Below 1:1 — cannot pay all short-term debts; risk of insolvency
• Ideal range: 1.8:1 to 2:1 (depends on the type of business)
• Too high (above 2:1) — underutilised current assets:
  • Excessive inventory (high holding costs; cash tied up)
  • High trade receivables (cash tied up; increased bad debt risk)
  • High bank balance (not earning interest)

Liquid capital ratio (acid test)

Excludes closing inventory from current assets because inventory is the least liquid current asset:

• Cannot be immediately converted to cash

• Delays include: selling on credit → trade receivable → cash receipt

• The inventory excluded is closing inventory only

• Above 1:1 — can pay short-term debts without needing to sell inventory

• Below 1:1 — relies on selling inventory to meet short-term obligations

• Ideal range: 1.2:1 to 1.5:1

Worked example (Geraint Roglic)

Current assets: inventory £27 000 + bank £5 000 + receivables £18 000 = £50 000 Current liabilities: £12 500

Current ratio of 4:1 is above the ideal — suggests underutilised current assets.