Liquidity Analysis

These ratios assess the liquidity/solvency of a business (i.e. the ability to meet debt obligations) and how efficiently the company manages its working capital resources.

Current ratio

Current or working capital ratio:

Current assets / current liabilities.

This is usually presented as a ratio in the format of '4:1.'

 The current ratio measures the adequacy of current assets to meet liabilities as they fall due.

A high or increasing figure may appear safe but should be regarded with suspicion as it may be due to:

• high levels of inventory and receivables (this could mean inventory is unsaleable or that credit control is weak)
• high cash levels which could be put to better use (e.g. by investing in non-current assets).

Traditionally, a current ratio of 2:1 or higher was regarded as appropriate for most businesses to maintain creditworthiness. However, more recently a figure of 1.5:1 is regarded as the norm.

The current ratio should be, however, looked at in the light of what is normal for the business. For example, supermarkets tend to have low current ratios because:

• there are few trade receivables
• there is a high level of trade payables
• there is usually very tight cash control, to fund investment in developing new sites and improving sites.

It is also worth considering:

• availability of further finance, e.g. is the overdraft at the limit? – very often this information is highly relevant but is not disclosed in the accounts
• seasonal nature of the business – one way of doing this is to compare the interest charges in the income statement with the overdraft and other loans in the statement of financial position; if the interest rate appears abnormally high, this is probably because the company has had higher levels of borrowings during the year
• long-term liabilities, when they fall due and how will they be financed
• nature of the inventory – where inventories are slow moving, the quick ratio probably provides a better indicator of short-term liquidity.

Quick ratio

This is calculated as:

Current assets - inventory / current liabilities

The quick ratio is also known as the acid test ratio because by eliminating inventory from current assets it provides the acid test of whether the company has sufficient liquid resources (receivables and cash) to settle its liabilities.

Normal levels for the quick ratio range from 1:1 to 0.7:1.

Like the current ratio it is relevant to consider the nature of the business (again supermarkets have very low quick ratios).

Sometimes the quick ratio is calculated on the basis of a six-week time-frame (i.e. the quick assets are those which will turn into cash in six weeks; quick liabilities are those which fall due for payment within six weeks). This basis would usually include the following in quick assets:

• bank, cash and short-term investments
• trade receivables.

thus excluding prepayments and inventory.

Quick liabilities would usually include:

• bank overdraft which is repayable on demand
• trade payables, tax and social security
• dividends.

Income tax liabilities may be excluded.

When interpreting the quick ratio, care should be taken over the status of the bank overdraft. A company with a low quick ratio may actually have no problem in paying its amounts due if sufficient overall overdraft facilities are available.

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