The liquidity of a business is the measurement of the assets that it has readily at its disposable to pay out sums of money. There are various calculations that can be used as an assessment of liquidity and they are designed to demonstrate, among other things, how efficiently the operations are at collecting money owed to it.
To illustrate some of the calculation, an extract of a business’ balance sheet is be used.
Current Assets
Cash at bank £10,000
Trade debtors £50,000
Stock £40,000
Total £100,000
Current Liabilities
Trade Creditors £5,000
VAT and PAYE £15,000
Loans due within one year £40,000
Total £60,000
Current Ratio
The current ratio is a well known measure of a business’ short term financial viability and is an indication of the likelihood of it being able to survive in the immediate future without liquidating any longer term assets.
As a rough guide, the amount of current assets should be twice that shown for current liabilities. This suggests that the business has adequate working capital and even in the event that it has bad debts or some obsolete stock it would still fair well in being able to continue.
The current ratio is calculated as current assets divided by current liabilities and using the figures above would be (£100,000 / £60,000) 1.67.
Although this figure is below 2, it still represents a healthy picture of the business’ short term finances.
Quick Ratio – Acid Test
This calculation is similar to the current ratio but acknowledges that stock is probably the least liquid asset contained in the grouping. This is because; under normal circumstances stock must first be sold and translated in to a debtor, which in turn must then be converted in to cash before it can then be used to pay liabilities.
The quick ratio therefore removes stock from the calculation to provide a more useful calculation as to the viability of the business.
Again, based on the figures in the above example, the acid test would be stated as (£100,000 - £40,000 / £60,000) 1. A quick ratio of 1 is regarded as ideal and demonstrates good liquidity within the business.
It should be noted that although most people viewing the current and quick ratios will look for current assets to sufficiently cover the short term liabilities of the business, and thus demonstrate that it has a sensible level of liquidity.
Ratios which are too high however might be indicative of a business that is not using its resources wisely to generate more profit. Cash and other liquid assets usually yield low or no income for the business and as such their amounts should be restricted to levels which are necessary for it to pay liabilities.
Current assets above this level could be better utilised in higher yielding investments, fixed assets or as a return to investors.