Liquidity Ratios: Current Ratio and Acid-Test Ratio
- Liquidity ratios show whether a business has enough money to pay its bills.
- If a company runs out of cash, it can’t pay suppliers, employees, or rent, even if it’s making profits on paper.
- That’s why liquidity is just as important as profitability, a business that can’t pay its debts when they’re due is in trouble.
Liquidity Ratios
Liquidity Ratios measure a company's ability to meet short-term financial obligations.
The Current Ratio
Current Ratio
The Current Ratio is a liquidity ratio that measures a company's ability to pay short-term obligations using its current assets.
- The current ratio checks if a business has enough current assets (things that can be quickly turned into cash, like cash itself, accounts receivable, and inventory),
- To cover its current liabilities (short-term debts like supplier payments and loans due soon).
- A ratio above 1 indicates that a company has more current assets than liabilities, suggesting good short-term financial health.
Current Ratio Formula
$$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$
Example- A business with €20 million in current assets and €10 million in current liabilities has a current ratio of 2:1.
- This means it has €2 of current assets for every €1 of short-term debt—a solid financial position.
What to Watch Out For
- In the past, a 2:1 ratio was seen as ideal, but today many businesses operate efficiently with 1.6:1.
- If the current ratio is too high, say 3:1 or more, it might mean the company is holding too much cash or inventory instead of investing it wisely.
- Fast-food chains (like McDonald’s) operate with low current ratios because they sell fast and get paid in cash.
- On the other hand, manufacturers often have higher current ratios because they keep more inventory on hand.
The Acid-Test (Quick) Ratio: A Stricter Measure
Acid Test Ratio
The Acid Test Ratio, also known as the Quick Ratio, measures a company's ability to meet short-term liabilities using its most liquid assets (excluding inventory).
- The acid-test ratio, also called the quick ratio, is a stricter test.
- It removes stock from current assets because inventory can take time to sell, meaning it’s not as “liquid” as cash.
- Understand that $$\text{Quick Assets = Current Assets - Inventory - Prepaid Expenses}$$
A ratio of 1 or more is generally considered healthy.
Acid Test Formula
$$\text{Acid-Test Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$$
ExampleA business with €12 million in current assets, €4 million in stock, and €6 million in current liabilities would have an acid-test ratio of 1.33:1.
