liquidity-ratios

Liquidity is the ability of a business to pay back its short-term debts, e.g. its suppliers

A businesses that cannot pay its debts is considered insolvent

• If a business cannot pay its suppliers, raw materials or components may not be delivered and production will be delayed

• If it cannot repay an overdraft, banking facilities may be withdrawn, and its credit rating will suffer

• Creditors may force it to stop trading and sell its assets so that the debts owed to them are repaid

The Current Ratio is a quick way to measure liquidity and the outcome is expressed as a ratio

All forms of current asset are considered in this ratio

The current ratio is an effective liquidity measure for businesses that hold little stock

The result indicates how well current assets can cover short-term debt

It is calculated using the formula

The acid test ratio is a precise and realistic way to measure liquidity, especially for businesses that hold large amounts of inventory

• It is expressed as a ratio

• It is also known as the liquid capital ratio

• The least liquid form of current assets (inventory) 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 inventory so it is excluded

• It is calculated using the formula

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