LIQUIDITY
RATIOS: Current ratio and Acid Test ratio (see pages 545-546)
LIQUIDITY:
the ability of a company to pay its short term debts
Current
Ratio: compares the company´s current assets with its current liabilities
How is it calculated?
Current ratio = Current assets/current
liabilities (CA/CL)
What does
it mean?
The result
can be expressed as a ratio (eg 2:1) or a number (eg 2). There is no “best” value for the current
ratio as it very much depends on the industry the company is operating in. Therefore the current ratio result is best
used when comparing companies in the same industry or within an individual
company to compare this year with previous years. However a current ratio of
less than 1 means the firm is illiquid (its CL are higher than its CA).
Acid
Test Ratio: compares the liquid assets with current liabilities
Why do we
use this ratio?
The current
assets figure used the current ratio includes inventories (stock). However we need to consider how liquid this
stock is – i.e. how easy is it to turn into cash (sell). In some cases this will be very easy (eg if
the stock is in demand by other businesses or customers) but in other cases it
is not – for example if it is perishable (eg food which cannot easily be sold
on to someone else) or if it very specialized (eg specific components for one particular
product which no other company would be interested in). For this reason, we sue the acid test ratio,
which only considers liquid assets (i.e. cash or cash-like assets).
How is it calculated?
Acid Test ratio = liquid assets/current
liabilities
Liquid
assets = Current assets – inventories (stock)
What does
it mean?
The acid
test ratio can be interpreted similarly to the current ratio (but of course it
will be smaller). If the acid test ratio is less than 1 it can be seen to be
illiquid (though in some industries this is the norm – especially if stock is
very liquid).
Now look at
table 29.7 on p548 to see how a firm
can improve its liquidity.
