IB Business Management HLTopic 3 — Finance and AccountsPaper 1 & 2Core skill~8 min read
Measuring Liquidity
A business can be profitable on paper and still shut down next month. Profit is measured over a year; bills arrive on Friday. Liquidity ratios ask a simple, brutal question: if everything the firm owes in the short term fell due right now, could it pay?
What you need to know
Liquidity is how easily a business can turn what it owns into cash to pay short-term bills.
The current ratio = current assets ÷ current liabilities. It counts everything.
The acid test ratio = (current assets − stock) ÷ current liabilities. It takes stock out.
Both answers are written as a ratio to 1, for example 2.10 : 1.
Roughly 1.5 : 1 to 2 : 1 is comfortable for the current ratio, and around 1 : 1 for the acid test — but this varies a lot by industry.
Too high is a problem too: idle cash and unsold stock earn nothing.
Why stock is the troublemaker
Current assets are not all equal. Cash is money already. Debtors are money that will arrive, probably, in a few weeks. Stock is not money at all yet — somebody has to want it, buy it, and then pay for it. That is why there are two ratios instead of one.
Only the top three rungs are current assets. The acid test keeps just the top two.
The current ratio
This is the quick check. It tells you how many dollars of current assets the business holds for every $1 of short-term debt.
Current ratio
current assets ÷ current liabilities = ? : 1
A result of 2 : 1 means $2 of current assets cover every $1 owed. Below 1 : 1 the firm literally does not have enough short-term assets to cover its short-term bills. The current ratio suits businesses that hold little stock, such as a hairdresser or a consultancy, because for them nearly all current assets really are close to cash.
The acid test ratio
Also called the liquid capital ratio. It strips stock out and asks the tougher question. It is the ratio that matters most for firms holding a lot of stock, such as a clothes shop or a car dealer, because their current ratio can look healthy while the shelves are full of things nobody is buying.
Acid test ratio
(current assets − stock) ÷ current liabilities = ? : 1
The same business looks comfortable on one ratio and only just safe on the other.
WORKED EXAMPLE 1
Both liquidity ratios
Mendez Sports has current assets of $84,000, of which stock is $36,000. Current liabilities are $40,000. Calculate the current ratio and the acid test ratio. [4]
Step 1: current ratio84,000 ÷ 40,000 = 2.12.10 : 1Step 2: take the stock out84,000 − 36,000 = $48,000Step 3: acid test ratio48,000 ÷ 40,000 = 1.21.20 : 1Mendez holds $2.10 of current assets, but only $1.20 of quick assets, for every $1 it owes in the short term.
WORKED EXAMPLE 2
When the two ratios disagree
A rival, Orbit Outdoors, has current assets of $60,000 including stock of $34,000, and current liabilities of $50,000. Calculate both ratios and comment. [4]
Step 1: current ratio60,000 ÷ 50,000 = 1.21.20 : 1Step 2: acid test ratio(60,000 − 34,000) ÷ 50,000 = 26,000 ÷ 50,000 = 0.520.52 : 1More than half of Orbit’s short-term debt is not covered once stock is ignored. If suppliers demanded payment now, Orbit would have to sell stock in a hurry, probably at a discount.
The gap between a firm’s two ratios is a stock warning light. A wide gap means the business is holding a lot of stock — fine for a supermarket, worrying for a fashion retailer at the end of a season.
Reading the result
Result
What it suggests
What to watch
Well below 1 : 1
The firm cannot cover short-term debts from short-term assets
Risk of failing to pay suppliers; may need an overdraft fast
Around 1 : 1 to 2 : 1
Usually a healthy, workable position
Depends on the industry and how fast stock sells
Well above 2 : 1
Very safe, but money may be sitting idle
Cash earning nothing, or too much stock in the warehouse
Falling year on year
Liquidity is being squeezed
Find the cause in the case study before recommending anything
There is no perfect ratio. A supermarket sells its stock in days and gets paid instantly, so it can run happily on an acid test well below 1 : 1. A machinery maker with six-month build times cannot.
Ways to improve liquidity
Method
How it helps
The trade-off
Shorten the credit period given to customers
Cash arrives sooner, so debtors turn into cash
Customers may move to a rival offering longer credit
Ask suppliers for longer to pay
Cash stays in the business for longer
Suppliers may refuse, or charge more
Sell off slow-moving stock
Turns dead stock into cash and cuts storage costs
Usually means discounting, so profit per unit falls
Sale and leaseback of a fixed asset
Brings in a lump of cash while still using the asset
Ongoing lease payments and the asset is no longer owned
Arrange an overdraft or short-term loan
Instant access to cash when there is a gap
Interest costs, and current liabilities go up
Owner introduces new capital
Current assets rise with no new debt
Control may be diluted if outside investors are used
Exam tip
Always finish the answer with “: 1”. A bare number is an incomplete ratio.
Round to two decimal places unless told otherwise.
Read carefully: “inventory”, “stock” and “closing stock” all mean the same thing here.
If a question gives you a stock figure, it is a strong hint that the acid test is wanted.
In evaluation, link liquidity to the case: seasonal firms dip at predictable times of year.
Say what the ratio means for the business, not just whether it is “good” or “bad”.
Common mix-up
Confusing liquidity with profit. A firm can be profitable and still run out of cash, because customers may not have paid yet.
Including fixed assets. Only current assets go into these ratios.
Forgetting the overdraft. An overdraft is a current liability, so it belongs on the bottom of the fraction.
Subtracting stock from current liabilities. Stock comes off the top, never the bottom.
Assuming higher is always better. A ratio of 4 : 1 usually means money is doing nothing.
Treating working capital and cash as the same thing. Working capital includes stock and debtors, which cannot pay a bill today.
Up next: HL Stock Turnover and Gearing — how quickly the shelves empty, and how much of the business the lenders really own.
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