5.5.2 Liquidity and Liquidity Ratios
| In this lesson you will learn: |
|---|
✅ The concept and importance of liquidity |
The Concept and Importance of Liquidity
While profitability is linked to income statements, liquidity is all about measuring cash flow and how efficiently a firm is managing the cash in its business.
Liquidity is the ability of a business to pay its short term debts. Cash flow is crucial to a business’s survival. If a business doesn’t have enough cash, it can’t pay it’s short term debts and it will become illiquid, insolvent and stop operating.
However, if a business has too much cash it means there is an opportunity cost. If that cash is not needed to pay short term debts it means that it could be used more effectively elsewhere and re-invested in the business.
Current Ratio
The current ratio guides businesses to find the most suitable level of cash so there is enough cash to pay short term debts, but not too much cash which could be used more effectively elsewhere in the business.
| Current Ratio = Current Assets ÷ Current Liabilities Acid Test Ratio = Current Assets – Inventory ÷ Current Liabilities |
| ⚠⚠ DANGER! ⚠⚠ Unlike the profitability ratios, liquidity ratios are not converted into a percentage, so don’t multiply by 100. |
| Extract from B. Eilish Hoodies Statement of Financial Position | ||
| 2019 | 2020 | |
| Current Assets $m | 350 | 450 |
| Current Liabilities $m | 250 | 300 |
| Non-current Liabilities $m | 480 | 520 |
| Inventory | 200 | 250 |
To calculate the current ratio in 2019 we divide current assets by current liabilities. So it is 350 divided by 250, giving a result of 1.4.
For 2020 we follow the same process. So it is 450 divided by 300, giving a result of 1.5.
| Current Ratio Calculation for B. Eilish Hoodies | |
| 2019 350 ÷ 250 = 1.4 | 2020 450 ÷ 300 = 1.5 |
But what do these results mean for B. Eilish Hoodies liquidity?
Generally the best current ratio result is somewhere between 1.5 and 2.0. Below 1.5 there is a danger that the business will not have enough cash to be able to pay its short term debts.
From 2019 to 2020 the current ratio has improved from 1.4 to 1.5, so the business is now in a better position in terms of liquidity.
| Current Ratio Value | Explanation | |
| Above 2.0 | !!! | Too high, cash could be used more effectively elsewhere in the business |
| 1.5 to 2.0 | + | Correct level, enough cash to pay short term debts. |
| 1.0 to 1.5 | X | Too low, business may not be able to pay short term debts |
| Below 1.0 | X X | Danger! More current liabilities than current assets. |
Acid Test Ratio
To calculate the acid test ratio in 2019 we subtract inventory from current assets, then divide by current liabilities. So it 350 minus 200 divided by 250 giving a result of 0.6.
For 2020 we follow the same process, so we subtract inventory from current assets, then divide by current liabilities. So it is 450 minus 300 divided by 300 giving a result of 0.5.
| Acid Test Ratio Calculation for B. Eilish Hoodies | |
| 2019 (350- 200) ÷ 250 = 0.6 | 2020 (450-300) ÷ 300 = 0.5 |
But what do these results mean? The optimum figure for Acid Test Ratio is 1.0, so B.Eilish is well below that in 2019 and in 2020 the situation is even worse. This means that B.Eilish may have difficulty paying short term debts and is at risk of not having enough cash flow for the business to continue operating.
| Acid Test Ratio Value | Explanation | |
| Above 1.0 | + | Enough cash to pay short term debts. |
| Below 1.0 | X | Too low, business may not be able to pay short term debts |
The reason we subtract inventory from current assets to calculate the acid test ratio is that inventory is the most difficult current asset to convert to cash. If there is an electricity bill that needs to be paid B.Eilish can’t offer to pay with her inventory of hoodies!
However, the optimum level of cash and inventory held by a business also varies from industry to industry. Some businesses will quickly sell their inventory, like fresh food markets. Others like jewellery shops will take much longer to sell off their inventory.
You have now completed all the calculations required in Unit 5. But who actually wants to look at all this financial information anyway? In the next section we’ll find out.
