Liquidity Analysis
In this lesson, we will learn how to calculate and interpret the current ratio and quick ratio and compare the liquidity performance across different years of the business, and with other businesses.
Related Lessons:
Purpose of Liquidity Management
Liquidity refers to the ability of a business in repaying its current debts and funding its daily business operation with its current assets. Therefore, it is important for the business as insufficient liquidity may lead to:
- Inability to repay debts on time thereby losing cash discounts
- Inability to purchase goods on credit thus losing bulk discount
- Loss of trust by staffs and customers
- Lost investment opportunities
Calculating Current & Quick Ratios
The two liquidity ratios that are covered in this lesson are:
A) Current Ratio
This ratio measures the ability of a business to pay its current debts with its current assets, ideally at a ratio of 2:1.
To calculate, we take Current Assets divided by Current Liabilities. This gives us the amount of current asset to repay $1 of current debt.
Current Assets / Current Liabilities = x:1
B) Quick Ratio
This ratio measures the ability of a business to pay its short-term debts using its quick (or immediate) assets, ideally at a ratio of 1:1.
To calculate, we take Current Assets minus Inventory and Prepaids divided by Current Liabilities. This gives us the amount of quick asset to repay $1 of current debt.
Current Assets – Inventory – Prepaids / Current Liabilities = x:1
Interpreting Current & Quick Ratios
The ideal ratio for Current Ratio is 2:1. This means that the business has $2 of current asset to repay every $1 of its current liability. This ratio is considered ideal as the business is able to repay its current debt in full and still have excess current asset to meet investment opportunities.
While it is an ideal ratio, falling below this ratio does not necessarily mean that the business is not liquid.
A business is only considered not liquid when it has insufficient current asset to repay its current debt. That is, a current ratio with current asset falling below 1, example, 0.9:1.
The ideal ratio for Quick Ratio is 1:1. This means that the business has $1 of quick asset to repay every $1 of current debt. This is an ideal ratio because the business can fully repay its current debts without keeping too much cash idle.
When the business has insufficient quick assets (i.e., when the quick ratio falls below 1), it is considered not liquid.
To improve the business liquidity,
- Owner may inject additional capital
- Restructure or take up a loan
- Sell unwanted non-current assets
- Invite investors