ratio analysis liquidity

What is Liquidity?

Liquidity is the ability of a business to pay its way—settle liabilities such as monthly payroll, amounts due to suppliers, and taxes collected on behalf of the government.

What is a Liquidity Ratio?

A liquidity ratio assesses whether a business has sufficient cash or equivalent current assets to pay its debts as they fall due.

Where does the data to calculate liquidity ratios come from?

From the Statement of Financial Position (Balance Sheet), including income statement, statement of financial position, and cash flow statement.

What are current assets?

Assets such as cash, inventories, and trade receivables (amounts owed by customers).

What are current liabilities?

Amounts owed to suppliers and any bank overdraft balances (money owed to the bank).

How do you calculate the Current Ratio?

Current Ratio = Current Assets ÷ Current Liabilities

Calculate the Current Ratio with: Cash = £10,000, Inventory = £30,000, Debtors = £60,000, Creditors = £45,000, Overdraft = £5,000.

Current Assets = £100,000, Current Liabilities = £50,000, Current Ratio = 100,000 ÷ 50,000 = 2.0

What does a current ratio of 1.5 - 2.5 indicate?

Acceptable liquidity and efficient management of working capital.

What does a low current ratio (below 1) indicate?

Possible liquidity problems.

What does a high current ratio indicate?

Too much working capital tied up in inventories or debtors.

Why is it important to consider industry or market matters when evaluating the current ratio?

Different industries have different requirements for holding inventories or approaches to trade debt and credit.

What should you consider about competitors when looking at the current ratio?

How the current ratio compares with competitors.

What is a sudden deterioration in the current ratio a good indicator of?

A sudden deterioration may signal a trading problem.