Chapter 23 - Analysis of Accounts
Lesson Objective: To understand how to calculate and interpret liquidity ratios
Liquidity:
Liquidity is a business access to cash - ability to pay its short-term debts. It is an important measure as it relates to business survival and therefore liquidity ratios should be monitored constantly:
Current Ratio
Acid-Test Ratio
To understand Liquidity Ratios we will be making use of the following information:
The Current Ratio shows the ratio between Current Assets and Current Liabilities:
Current Assets are assets owned by the business that can easily and quickly be converted into cash if it needs to (<12 months);
Current Liabilities are the short-term debts to be paid in the near future (<12 months).
A healthy business needs to have a higher ratio of current assets compared to its current liabilities. If not, it will run in to liquidity problems: not enough cash to pay short-term debts.
What is a good Current Ratio then? A current ratio between 1.5 and 2 is the best:
Lower than 1.5 may be dangerous (insolvency) in case of unexpected expenses;
Higher than 2 is not advisable because the business might have too much cash tied to current assets (non-profitable assets), which is an opportunity cost.
Calculate the Current Ratio using the table:
The Acid-Test Ratio is slightly different from the Current Ratio:
This calculation only considers assets that are liquid - it excludes inventories because:
- They might or might not be sold within 12 months;
- Inventory sold on credit will take long to materialize into cash.
As it only considers liquid assets on its calculation, the Acid-Test Ratio is a 'better' and more accurate liquidity ratio.
Therefore, Acid-Test Ratio formula is:
How to look at the Acid-Test Ratio results?
Results of 1 are satisfactory;
Results lower than 1 is risky since the business might not be able to bare its short-term debts;
Results higher than 1 represent that cash is tied up to unprofitable assets.
Activity 23.5
Improving Liquidity:
When businesses find themselves having liquidity issues they can:
Reduce inventories to decrease the amount of cash tied up to it
- More cash to pay its short-term debts;
Try to recover money from trade receivables quicker.
Activity 23.6
To-Do-List:
Exam Practice Question #1 (p. 294)
Chapter 23 - Analysis of Accounts
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