3) Liquidity - Current Ratio

Liquidity - Degree to which an asset can be quickly converted to cash without affecting its value.


Current ratio is used to measure the business liquidity.

It compares current assets and liabilities to calculate if the business can meet its financial obligations that come due within on year.



CURRENT ASSETS

Items of value that are expected to be converted to cash within a year.

  • Cash

  • Accounts receivable / debtors

  • Stock/inventory


CURRENT LIABILITIES

Financial debt that needs to be paid within a year.

  • Accounts payable / creditors

  • Short term loans payable

  • Bank overdraft


Interpretation

To cover short term debts the business ideal is 2:1 or 200%.

“For every $1 of current liabilities the business has $2 of current assets to pay the SHORT TERM debt as it falls due.”

Current ratio must be analysed in the context of the norms of a particular industry, e.g. manufacturing industries expect high current ratios due to the requirement of large investment into inventory, trade debtors, cash, etc.


EXAMPLE:

Describe:

Liquidity is decreasing, having decreased by $0.05 over the past two years (from 2026 to 2027) - must show interpretation, not just repeating provided data.

With a current ratio above $1 by $0.39, it means that the company is able to repay their short term debts.

Analyse:

However, their current assets mainly consist of Accounts Receivable. They will need to ensure they get their debtors to repay their accounts on time, or they may have difficulties fulfilling their own Accounts Payable.


LOW (less than $1)

Indicates that the business may be unable to pay its SHORT TERM debts.

Reasons for low current ratio:

  • Limited cash flow due to low sales - sell excess stock/inventory.

  • Customers delaying payment - ensure all accounts receivable are collected.

  • High amount of short-term debt (current liabilities) - renegotiate short term debts.



HIGH (above $2)

A high current ratio indicates that the business is able to pay SHORT TERM debts as they fall due withing the next year.

ISSUES:

  • Not using its current asset resources to the best advantage (could be used for long-term savings account or to increase productivity/efficiency of the business)

  • Large amounts of stock - may go out of date, especially in international businesses needing to allow for transit time.

  • High levels of inventory - products are not selling, may need to ensure they have a distinct competitive advantage in the global market and are catering to the demands.

  • Large amounts of accounts receivables - poor management of collecting money from debtors, which can be difficult when operating across different legal systems and laws regarding debt collection.