The Current Ratio
- Liquidity refers to the cash and other current assets businesses have available to quickly pay bills and meet short-term financial obligations
- The liquidity of a business can be measured using two ratios
- Current ratio
- Acid test ratio
The current ratio
- The Current Ratio is a quick way to measure liquidity
- The outcome is expressed as a ratio
- All types of current asset are included in calculating this ratio
- The result indicates how many £s (or other currency units) of current assets are available to cover each £1 (or other currency unit) of short-term debt
- It is calculated using the formula
Worked example
Packer Sports Ltd has current assets of $15,545, current liabilities of $5,060 and an inventory (stock) figure of $8,250.
Calculate Packer Sports Ltd.’s current ratio. [2]
Step 1: Substitute the values into the equation
[1 mark]
Step 2: Express the outcome as a ratio
[1 mark]
In this example, Packer Sports Ltd has $3.07 of current assets to cover each $1 of short-term debt
The acid test ratio
- The acid test ratio is a precise and realistic way to measure liquidity, especially for businesses that hold large amounts of stock
- It is expressed as a ratio
- It is also known as the liquid capital ratio
- The least liquid form of current assets (stock) is deducted so the acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly
- It often takes time to sell stock so it is excluded
- It often takes time to sell stock so it is excluded
- The Acid Test is calculated using the formula
Worked example
Packer Sports Ltd has current assets of $15,545, current liabilities of $5,060 and a stock figure of $8,250.
Calculate Packer Sports Ltd’s acid test ratio. [3]
Step 1: Subtract stock from current assets
[1 mark]
Step 1: Substitute the values into the equation
[1 mark]
Step 2: Express the outcome as a ratio
[1 mark]
In this example, Packer Sports Ltd has $1.44 of the most liquid current assets to cover each $1 of short-term debt