Ratios

Liquidity Ratios

Under the syllabus, liquidity ratios consist of two main ratios, the current ratio/working capital ratio and the quick asset ratio. 

Current Ratio/Working Capital Ratio

The current ratio measures the amount of total current assets relative to total current liabilities.

 

 

 

 

Interpretations

Acceptable ratio levels are dependent on each industry; therefore, current ratios should be compared to industry averages as well as past performance.

 

Generally speaking, the usual interpretations are:

Low (Between 0%-99%)

A low current ratio suggests the business has insufficient current assets to repay current liabilities and may have difficulties repaying its short term debts.

Medium (Between 100%-200%)

The business has sufficient current assets to meet its short term liabilities. This level is usually ideal for a business.

High (Over 200%)

This level suggests the business has a very high level of current assets relative to current liabilities and these assets could be used more efficiently elsewhere in the business. (Such as purchasing non-current assets or repaying non-current liabilities)

 

Quick Asset Ratio

The quick asset ratio measures the amount of liquid assets relative to current liabilities excluding overdraft.

 

 

Why is Inventory and Prepayments Excluded?

Inventory and Prepayments are not very liquid assets.

Inventory is only liquid when sold at a discount price and is not very liquid at its normal selling price.

Prepayments are not very liquid as they are hard to recover and are usually essential in the running of a business. For example, it’s not very reasonable to meet short term debt obligations by selling prepaid insurance. Eventually, the business will need that insurance again.

 

Interpretations

Acceptable ratio levels are dependent on each industry; therefore, quick asset ratios should be compared to industry averages as well as past performance.

Generally speaking, the usual interpretations are:

 

Low (Between 0%-99%)

A low quick asset ratio suggests the business does not have sufficient liquid assets to meet short term debts. In an emergency, the business will not be able to repay its debts.

Medium (Between 100%-200%)

The business has a sufficient level of liquid assets to meet short term obligations.

High (Over 200%)

This level suggest the business has too much liquid assets and these assets are not being used efficiently.

For example, this could be due to a high levels of cash at bank balance, which give very low returns.

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