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Liquidity ratios Cambridge IGCSE Accounting (9–1) revision

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In plain words

A business can be profitable and still fail, if it cannot pay its bills when they fall due. Liquidity is the ability to pay short-term debts, and two ratios measure it.

5 things to know

  1. Working capital = current assets − current liabilities. It is the money available for day-to-day running.
  2. Current ratio = current assets ÷ current liabilities. It is written as a ratio, such as 1.8 : 1.
  3. Acid test (liquid) ratio = (current assets − inventory) ÷ current liabilities. Inventory is left out because it takes longest to turn into cash.
  4. A current ratio between about 1.5 : 1 and 2 : 1, and an acid test ratio of about 1 : 1, are usually regarded as satisfactory, though this depends on the type of business.
  5. A ratio that is too low means the business may be unable to pay its debts. One that is too high means money is tied up in inventory, trade receivables or the bank and is not being put to use.

Worked example

Current assets are $45 000, including inventory of $18 000. Current liabilities are $25 000. Calculate the working capital, the current ratio and the acid test ratio.

  1. Working capital = 45 000 − 25 000 = $20 000.
  2. Current ratio = 45 000 ÷ 25 000 = 1.8 : 1.
  3. Acid test ratio = (45 000 − 18 000) ÷ 25 000 = 27 000 ÷ 25 000 = 1.08 : 1.

Tips and tricks

  • Give liquidity ratios in the form "x : 1". An answer of 1.8 with no ": 1" loses the mark, and so does a percentage.
  • If the current ratio looks healthy but the acid test ratio is poor, the business is holding a lot of inventory.
5 questions, about 2 minutes.

It lands in your notebook with its questions as flashcards.

Liquidity ratios: 5 questions and answers

These are the quiz’s questions. Do the quiz first, then come back here for the ones that got you.

  1. How is the current ratio calculated?
    • current liabilities ÷ current assets
    • current assets ÷ current liabilities (the answer)
    • current assets − current liabilities
    • total assets ÷ total liabilities

    The answer is given as a ratio to 1.

  2. Which item is left out of the acid test ratio?
    • bank
    • trade receivables
    • inventory (the answer)
    • trade payables

    It takes the longest to turn into cash.

  3. Current assets are $30 000 and current liabilities are $20 000. What is the working capital?
    • $50 000
    • $10 000 (the answer)
    • 1.5 : 1
    • $20 000

    30 000 − 20 000. Working capital is an amount, not a ratio.

  4. Current assets $50 000 (including inventory $20 000), current liabilities $25 000. What is the acid test ratio?
    • 2 : 1
    • 1.2 : 1 (the answer)
    • 0.8 : 1
    • 2.8 : 1

    (50 000 − 20 000) ÷ 25 000.

  5. What might a very high current ratio suggest?
    • The business cannot pay its debts.
    • Too much money is tied up in current assets. (the answer)
    • The business has no inventory.
    • The business is making a loss.

    Money sitting in inventory or in the bank is not earning anything.

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