Liquidity-Ratios Igcse Edexcel

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Exam code:4AC1

Liquidity

Liquidity is the measure of the ability of a business to repay its short-term liabilities
- It measures how much assets can be converted quickly into cash

The liquidity ratios are:
- Current (working capital) ratio
- Liquid (acid test) ratio

The current ratio is also known as the working capital ratio
- Working capital is current assets minus current liabilities

What is the formula?	$fraction numerator Current space assets over denominator Current space liabilities end fraction$
How should the value be written?	Write as a ratio (X : 1)
How should the value be rounded?	Round to two decimal places
What does the value mean?	The value represents the amount of current assets available to cover each $1 of current liability
How can the ratio be increased?	Increase current assets by introducing capital or selling non-current assets Reduce current liabilities, such as overdrafts and trade payables

A ratio close to 2:1 is generally good
- If it is less than 1:1 then the business does not have enough current assets to cover its current liabilities
- If it is too high then the business could have too much inventory or trade receivables
  - They need to improve their inventory control
  - They need to encourage credit customers to pay faster

Elena and Tom are in a partnership. They provide the following information at 31 March 2024.

Calculate the current ratio. Your answer should be correct to two decimal places.

Answer

Calculate the total current assets
- Trade receivables + Inventory + Bank
- $34 000 + $20 000 + $5 000 = $59 000
Calculate the total current liabilities
- Trade payables + Other payables
- $28 000 + $4 000 = $32 000
Calculate the current ratio
- $fraction numerator Current space assets over denominator Current space liabilities end fraction$
- $fraction numerator 59 space 000 over denominator 32 space 000 end fraction equals 1.84375$
Round to two decimal places and write as a ratio
- Current ratio = 1.84 : 1

What is the formula?	$fraction numerator Current space assets space minus space Inventory over denominator Current space liabilities end fraction$
How should the value be written?	Write as a ratio (X : 1)
How should the value be rounded?	Round to two decimal places
What does the value mean?	The value represents the amount of cash and receivables available to cover each $1 of current liability
How can the ratio be increased?	Increase current assets, especially cash, by introducing capital or selling non-current assets Reduce current liabilities, such as overdrafts and trade payables

A ratio close to 1:1 is generally good
- If it is above 1:1 then the business has enough current assets to cover its short-term debts even if the inventory cannot be sold
- If it is too high then the business could be owed too much by trade receivables</