Current assets are $60 000, inventories are $24 000 and current liabilities are $30 000. What is the acid test ratio?

1.2. (60 000 − 24 000) ÷ 30 000 = 1.2.

Why are inventories left out of the acid test ratio?

They may take time to sell and turn into cash. The test is whether debts can be paid without relying on stock.

A current ratio of 0.6 suggests that the business

may be unable to pay its short-term debts. It has only 60 cents of current assets for each dollar it owes.

Which user of accounts is most interested in whether a loan can be repaid?

the bank. A lender looks at profit and liquidity before lending.

Liquidity ratios, and who uses accounts · Cambridge IGCSE Business Studies

In plain words

Liquidity is about paying the bills. A business is liquid if it has enough cash, or things that will quickly become cash, to pay the debts that are about to fall due.

Two ratios measure it, and many people outside the business watch them closely.

5 things to know

Liquidity is the ability of a business to pay its short-term debts when they are due.
Current ratio = current assets ÷ current liabilities. A result of about 1.5 to 2 is usually thought safe.
Acid test ratio = (current assets − inventories) ÷ current liabilities. Inventories are left out because they may be slow to sell. A result of about 1 is usually thought safe.
A ratio that is too low means the business may not be able to pay its debts. One that is very high means money is sitting idle.
Users of accounts: managers (to take decisions), shareholders (whether to invest), banks and lenders (whether a loan will be repaid), suppliers (whether to give credit), the government (for tax) and employees (job security).

Worked example

A business has current assets of $90 000, of which $30 000 is inventories, and current liabilities of $60 000. Calculate both liquidity ratios.

Current ratio = 90 000 ÷ 60 000 = 1.5.
Acid test ratio = (90 000 − 30 000) ÷ 60 000 = 60 000 ÷ 60 000.
Acid test ratio = 1.

Tips and tricks

These two are ratios, not percentages. Write 1.5, or 1.5 : 1, not 150%.
The acid test is the tougher of the two. A business with a healthy current ratio and a poor acid test is relying on stock it has not yet sold.

5 questions, about 2 minutes.

It lands in your notebook with its questions as flashcards.

Liquidity ratios, and who uses accounts: 5 questions and answers

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

Current assets are $80 000 and current liabilities are $40 000. What is the current ratio?
- 0.5
- 1.5
- 2 (the answer)
- 40 000
80 000 ÷ 40 000 = 2.
Current assets are $60 000, inventories are $24 000 and current liabilities are $30 000. What is the acid test ratio?
- 0.8
- 1.2 (the answer)
- 2
- 2.8
(60 000 − 24 000) ÷ 30 000 = 1.2.
Why are inventories left out of the acid test ratio?
- They are not owned by the business.
- They may take time to sell and turn into cash. (the answer)
- They are a liability.
- They are worth nothing.
The test is whether debts can be paid without relying on stock.
A current ratio of 0.6 suggests that the business
- has too much cash
- may be unable to pay its short-term debts (the answer)
- is very profitable
- has no liabilities
It has only 60 cents of current assets for each dollar it owes.
Which user of accounts is most interested in whether a loan can be repaid?
- customers
- employees
- the bank (the answer)
- competitors
A lender looks at profit and liquidity before lending.

5 questions

Tap an answer and you’ll see straight away whether it’s right, and why.

Worksheet

4 questions, 11 marks. Write your answers on paper, then check them.

Liquidity ratios, and who uses accounts

Cambridge IGCSE Business Studies 0450 · 11 marks · papermunch.org

Name ______________________________ Date ______________

Define liquidity.[2]
Show answerHide answer
The ability of a business to pay its short-term debts as they fall due.
I got this one
A business has current assets of $72 000 and current liabilities of $48 000. Calculate its current ratio and comment on it.[3]
Show answerHide answer
Current ratio = 72 000 ÷ 48 000 = 1.5. It has $1.50 of current assets for every $1 of short-term debt, which is generally considered safe.
I got this one
Current assets are $50 000, including inventories of $20 000, and current liabilities are $40 000. Calculate the acid test ratio and comment on it.[3]
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Acid test ratio = (50 000 − 20 000) ÷ 40 000 = 0.75. It is below 1, so the business could struggle to pay its short-term debts without selling inventories.
I got this one
Explain why a bank would look at a business's accounts before lending to it.[3]
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The bank wants to know whether the business can afford the repayments. Its profit shows whether it earns enough, and its liquidity ratios show whether it can pay debts on time.
I got this one

Answers: Liquidity ratios, and who uses accounts

1. The ability of a business to pay its short-term debts as they fall due.
2. Current ratio = 72 000 ÷ 48 000 = 1.5. It has $1.50 of current assets for every $1 of short-term debt, which is generally considered safe.
3. Acid test ratio = (50 000 − 20 000) ÷ 40 000 = 0.75. It is below 1, so the business could struggle to pay its short-term debts without selling inventories.
4. The bank wants to know whether the business can afford the repayments. Its profit shows whether it earns enough, and its liquidity ratios show whether it can pay debts on time.