IB Business Management SLTopic 3 — Profitability & Liquidity RatiosPaper 1 & 2Core skill~11 min read
Measuring Liquidity
Liquidity is a simple question with serious consequences: if every short-term bill landed at once, could the business pay them? Firms fail from a lack of liquidity far more often than from a lack of profit.
📚 What you need to know
Liquidity is the ability to meet short-term debts with the assets you have available.
Current ratio = current assets ÷ current liabilities, written as a ratio to 1.
Acid test ratio = (current assets − stock) ÷ current liabilities, also written to 1.
The acid test takes out stock, because stock is the slowest current asset to turn into cash.
The current ratio suits firms holding little stock; the acid test matters most where stock is large.
Roughly 1.5 to 2 : 1 is comfortable for the current ratio, but it varies by industry.
Too high is also a problem — idle cash and unsold stock earn nothing.
The two ratios, side by side
Both compare what you can raise quickly against what you owe quickly. The only difference is whether stock counts.
Half of this firm’s current assets are sitting on shelves. If sales slow, that stock cannot pay Friday’s wages.
The two liquidity ratios
current ratio = current assets ÷ current liabilities acid test = (current assets − stock) ÷ current liabilities
Reading the number
A result of 2.5:1 means the firm has $2.50 of current assets for every $1 of short-term debt. But bigger is not automatically better.
Never say a ratio is “bad” without naming the industry. A cash-based retailer and a machinery manufacturer live in different worlds.
Improving liquidity
Method
What happens
The downside
Collect from customers faster
Debtors turn into cash sooner, raising current assets
Customers may move to rivals offering longer credit
Ask suppliers for longer to pay
Cash stays in the business longer
Current liabilities are unchanged; suppliers may refuse
Use an overdraft or short-term loan
Cash available immediately
Current liabilities rise, so the ratio can get worse
Sell excess stock
Slow stock becomes cash; storage costs fall
Discounting to shift it loses margin
Sale and leaseback
A large cash injection while still using the asset
Rent becomes a permanent new cost
Owner introduces new capital
Current assets rise with no new debt
Dilutes control if outside investors are used
Notice the trap in row three. Borrowing on an overdraft adds to current assets and to current liabilities, so the current ratio can fall even though the firm now has more cash. Spotting that is a top-band observation.
Worked examples
WORKED EXAMPLE 1
Both liquidity ratios [5 marks]
A retailer has current assets of $60,000, of which stock is $30,000, and current liabilities of $24,000. Calculate the current ratio and the acid test ratio.
Step 1: current ratio$60,000 ÷ $24,000 = 2.5Current ratio = 2.5 : 1Step 2: take out the stock$60,000 − $30,000 = $30,000Step 3: acid test$30,000 ÷ $24,000 = 1.25Acid test = 1.25 : 1say what it means: $2.50 of current assets per $1 owed, but only $1.25 once the shelves are ignored
WORKED EXAMPLE 2
Which firm would you lend to? [8 marks]
Firm A: current assets $90,000 (stock $70,000), current liabilities $50,000. Firm B: current assets $54,000 (stock $9,000), current liabilities $45,000. Both have asked for a short-term loan. Advise the bank.
Step 1: current ratiosA: 90,000 ÷ 50,000 = 1.80 : 1B: 54,000 ÷ 45,000 = 1.20 : 1Step 2: acid testsA: (90,000 − 70,000) ÷ 50,000 = 0.40 : 1B: (54,000 − 9,000) ÷ 45,000 = 1.00 : 1Step 3: read the reversal
On the current ratio A looks stronger. On the acid test A can cover only 40c of every $1 owed, because nearly all of its current assets are stock.
Lend to B, and ask A about its stock firstthe point of the example: the two ratios can rank the same firms in opposite orders, so always calculate both
💡 Exam tip
Write the answer as a ratio: 1.25 : 1, not 1.25 or 125%.
Two decimal places, and remember to subtract stock before dividing in the acid test.
State the meaning in dollars per $1 owed. It reads like understanding, not arithmetic.
Judge against the industry. Supermarkets and restaurants run low ratios quite safely.
Mention the trade-off with profitability: cash sitting idle is safe and unproductive.
Link to Topic 3.6. Poor liquidity is usually a cash flow problem, and the fixes overlap.
⚠ Common mix-up
Liquidity confused with profitability. A profitable firm can still run out of cash.
Forgetting to remove stock. That is the only difference between the two ratios.
Assuming higher is always better. Above 3 : 1 usually means money doing nothing.
Including non-current items. Only current assets and current liabilities go in these ratios.
Saying an overdraft fixes the current ratio. It adds to both sides of the calculation.
Giving a percentage. These two are ratios; the profitability ones are percentages.
Up next: Cash, Profit and Working Capital — the three ideas students most often blend into one, and how to keep them apart.
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