2.3.2 Liquidity

🔗 Liquidity = How much working capital a business has to pay its debts

🔗 Statement of financial position (balance sheet) = A financial document that summarises the net worth of a business at a single point in time.

It balances net assets with total equity

🔑 Net assets = What you spent the money on

🔑 Total equity = Where you got the money from

$$Current ratio = Current assets/Current liabilities$$

Ideal Current Ratio:

The ideal current ratio is between 1.5:1 and 2:1. This range indicates that a company has enough short-term assets to cover its short-term liabilities, suggesting good liquidity. A current ratio below 1.0 may indicate that a company could struggle to meet its short-term obligations, while a ratio significantly higher than 2.0 could suggest that the company is not using its assets efficiently to grow the business.

$$Acid test ratio = Current assets – Stock/Current liabilities$$

Ideal Acid Test Ratio:

A ratio of 1.0 or higher is ideal as it indicates that the company can meet its short-term obligations without relying on the sale of inventory, which suggests strong liquidity.

• A ratio below 1.0: Might indicate potential liquidity problems, as the company may not have enough liquid assets to cover its short-term liabilities without selling invent

Expressing the result as a ratio

Once you have done your calculation, put your answer in a ratio form. Let's look at an example:

Current Ratio Formula:

The current ratio is calculated using the formula:

Current Ratio = Current Assets/Current Liabilities

Example Calculation:

Let's say a company has:

• Current Assets: $150,000
• Current Liabilities: $100,000 Now, apply the values to the formula:

Current Ratio=150,000/100,000=1.5

The ratio:

The result of 1.5 can be expressed in ratio form as:

Current Ratio=1.5:1 = 1.5:1

Current Ratio=1.5:1

This means that for every $1 of current liabilities, the company has $1.50 in current assets. This ratio of 1.5:1 indicates that the company is in a good position to cover its short-term obligations.