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  Liquidity

Introduction to Liquidity

Liquidity ratios are considered with the capability of the business to meet its short-term financial obligations.

The subsequent ratios are extensively used:

  • current ratio
  • acid test ratio
  • operating cash flows to maturing obligations.

These three will now be considered.

Current ratio

The current ratio evaluates the 'liquid' assets (i.e. cash and those assets held which will soon be turned into cash) of the business along with the current liabilities. The ratio is expressed as follows:

Current ratio = Current status/Current liabilities

A number of people seem to believe that there is an 'ideal' current ratio (generally 2 times or 2:1) for all businesses. Though, this fails to take into account the fact that dissimilar types of business need dissimilar current ratios. For instance, a manufacturing business will frequently have a comparatively high current ratio because it is essential to hold inventories of work in progress, finished goods and raw materials. It will also generally sell goods on credit, thus providing rise to trade receivables. Alternatively, a supermarket chain will have a comparatively low ratio, as it will hold only fast-moving inventories of finished goods and all of its sales will be made for cash (no credit sales).

Acid test ratio

The acid test ratio is very identical to the current ratio, but it presents a more stringent test of liquidity. It could be argued that, for several businesses, inventories cannot be converted into cash rapidly. (Note: in the case of Alexis plc, the inventories turnover period was concerning 57 days in both years.)  The result, it may be better to not include this specific asset from any measure of liquidity. The acid test ratio is a difference of the current ratio, but not including inventories.

The minimum level for this ratio is frequently known as 1.0 times (or 1:1; i.e. current assets (not including inventories) equals current liabilities). In several highly successful businesses that are considered as containing adequate liquidity, though, it is usual for the acid test ratio to be below 1.0 without causing specific liquidity problems.

The acid test ratio is expressed as follows:

Acid test ratio = Current assets (excluding inventories)/Current liabilities

Cash generated from operations to maturing obligations

The cash produced from operations to maturing obligations ratio evaluates the cash produced from operations (taken from the statement of cash flows) along with the current liabilities of the business. It gives an additional indication of the ability of the business to meet its maturing obligations. .

The ratio is displayed as follow:

cash generated from operations to maturing obligations = cash generated from operations/ current liabilities

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