A good year, and a bill on the desk: Lena's Bakery Ltd made a profit of $85,000 in 2025. On 31 December the bank account holds $25,000.
On Marco's desk is Valley Grain's flour bill for $45,000, due within 30 days. Can the bakery pay it on time? The profit does not answer that. What matters is what the bakery can turn into cash, and how fast.
Being able to pay the bills that fall due soon is liquidity. A business is liquid when it has, or can quickly get, the cash for its short-term debts.
An asset is liquid when it can be turned into cash quickly without losing value. Cash is the most liquid thing a business owns. Everything else has to be turned into cash first, and some things take longer than others.
The bakery's current assets, from most liquid to least
Cash: $25,000
Money in the bank and in the tills. It can pay a bill today.
Debtors: $40,000
What the cafés and hotels that buy wholesale on credit still owe. It becomes cash when they pay, usually within a few weeks.
Stock: $15,000
Flour, butter and packaging in the Mill Lane store. It becomes cash only after it is baked, sold and paid for, and flour that goes out of date is worth nothing.
Profit
- What the year's sales earned after its costs (3.4.1).
Liquidity
- Cash on a single day, and the bills due soon after it.
Profit is not cash: A profitable business can run short of cash if its money is tied up in stock or owed by customers. Businesses that make a profit can still fail because they cannot pay a bill on time.
| Due within a year | Lena's Bakery Ltd at 31 December 2025 |
|---|---|
| Current assets (cash, debtors, stock) | $25,000 + $40,000 + $15,000 = $80,000 |
| Current liabilities (trade creditors, overdraft) | $45,000 + $15,000 = $60,000 |
| Working capital (current assets − current liabilities) | $80,000 − $60,000 = $20,000 |
The balance sheet (3.4.2) already sorts these lines. Current assets are cash and what will turn into cash within a year. Current liabilities are the debts due within a year: Valley Grain's bill (trade creditors) and the $15,000 overdraft.
Take one from the other and you get working capital (also called net current assets): Working capital = current assets − current liabilities. The bakery's is $20,000. If every short-term debt were paid today from the current assets, $20,000 would be left. A negative figure means the short-term debts are bigger than everything that can pay them.
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How many dollars for each dollar owed?: Working capital says $20,000 would be left over. But $20,000 spare means a lot to a bakery that owes $60,000 and very little to Goldcrust plc, which owes millions.
So compare the two figures by dividing instead: how many dollars of current assets does the bakery have for each dollar it must pay within the year?
That is the current ratio:
Current ratio = current assets ÷ current liabilities
The formula is printed on the formula sheet. The skill is picking out the right figures from a table that also holds long-term loans, buildings and sales.
Worked example: Lena's Bakery Ltd, 31 December 2025
Add up the current assets
Cash $25,000 + debtors $40,000 + stock $15,000 = $80,000.
Add up the current liabilities
Trade creditors $45,000 + overdraft $15,000 = $60,000. The $350,000 bank loan is due over many years, so it is a non-current liability and stays out.
Divide, assets on top
$80,000 ÷ $60,000 = 1.333... = 1.33 (write 1.33 or 1.33 : 1).
The bakery has $1.33 of current assets for every $1 it owes within the year.
| Current ratio | What it suggests | At the bakery |
|---|---|---|
| Below 1 | Current assets cannot cover the short-term debts, even if everything is collected and sold | If the bakery owed $90,000 within the year, it would have only $0.89 for each $1 |
| About 1.5 to 2 | Usually seen as comfortable: the debts are covered with room to spare | At 1.33 the bakery is covered, with a thinner cushion |
| Well above 2 | Safe, but money may be sitting idle in the bank or on the shelves instead of earning a return | With $150,000 of current assets (2.50), much of it would be cash and flour doing nothing |
Three slips that lose the answer: Upside down. $60,000 ÷ $80,000 = 0.75 answers a different question. Current assets always go on top, so write 1.33 or 1.33 : 1, never 1 : 1.33.
A dollar sign. A ratio has no unit. $1.33 is wrong; 1.33 is right.
No working. Write the formula, then the two totals, then the answer to two decimal places.
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Flour cannot pay the flour bill: Valley Grain will not take a sack of its own flour back as payment. The $15,000 of stock in the Mill Lane store has to be baked, sold and paid for before it is any use against a bill.
So a stricter test leaves the stock out and asks: could the bakery pay its short-term debts without selling a single extra loaf?
That is the acid test ratio (also called the quick ratio):
Acid test ratio = (current assets − stock) ÷ current liabilities
It is the current ratio with the least liquid current asset taken out, so it is never higher than the current ratio.
Worked example: the bakery's acid test
Take the stock out of current assets
$80,000 − $15,000 = $65,000: the cash and the debtors.
Divide by current liabilities
$65,000 ÷ $60,000 = 1.083... = 1.08.
Without selling any stock, the bakery has $1.08 for every $1 it owes within the year.
Reading the acid test: About 1 or above: the short-term debts can be paid without relying on selling stock.
Below 1: paying the bills depends on selling stock first. That is a risk if the stock sells slowly or goes out of date.
A big gap between the two ratios: much of the current assets is stock.
| Now | After a $20,000 bulk order of flour, paid in cash | |
|---|---|---|
| Cash | $25,000 | $5,000 |
| Stock | $15,000 | $35,000 |
| Current assets | $80,000 | $80,000 |
| Current ratio | $80,000 ÷ $60,000 = 1.33 | $80,000 ÷ $60,000 = 1.33 |
| Acid test ratio | $65,000 ÷ $60,000 = 1.08 | $45,000 ÷ $60,000 = 0.75 |
Suppose Valley Grain offers a discount if Lena pays now for two months of flour. The current ratio does not move: the money has only changed shape, from cash into flour. The acid test drops from 1.08 to 0.75. That is why a healthy current ratio can hide a weak position, and why both ratios are worth working out.
How low is too low depends on the business. The bakery's stock is small because it bakes every night and sells most of it for cash the next day. A shop that takes cash at the till every day can live with a lower acid test than a furniture maker whose chairs sit in a warehouse for months.
Two ways to lift a ratio: Every liquidity ratio is liquid assets divided by short-term debts.
To raise it, the bakery can
- Bring in more liquid assets from outside the current items.
- Cut its short-term debts.
Moving money between current assets: Moving money between current assets does less than it seems. Collecting $15,000 from the cafés turns debtors into cash: current assets stay at $80,000 and neither ratio moves, unless that cash is then used to pay off a debt.
| Strategy for the bakery | Current ratio | Acid test | The drawback |
|---|---|---|---|
| Turn a short-term debt into a long-term one: replace the $15,000 overdraft with a three-year bank loan | 1.33 → 1.78 | 1.08 → 1.44 | Interest is paid for three years, and the bakery's long-term debt grows |
| Collect debts faster and pay off a debt: $15,000 from cafés and hotels used to clear the overdraft | 1.33 → 1.44 | 1.08 → 1.11 | Shorter credit may send wholesale customers to a bakery that gives them longer |
| Sell an asset it no longer needs (3.2.1): an old van sold for $12,000 | 1.33 → 1.53 | 1.08 → 1.28 | One van fewer for the 5 a.m. deliveries; it may have to lease one instead |
| Keep more profit in the business: $10,000 less paid out in dividends | 1.33 → 1.50 | 1.08 → 1.25 | Lena, Marco and the cousin receive less, and a shareholder may be unhappy |
| Hold less stock: $5,000 of surplus stock sold at cost | 1.33 → 1.33 | 1.08 → 1.17 | Sold below cost, it cuts profit; too little stock risks running out of flour |
Each row is a trade. The overdraft swap gives the biggest lift but adds years of interest. Collecting debts faster costs nothing in cash but may cost customers. Holding back dividends is cheap for the business and unpopular with its owners.
So a good answer names the strategy, shows what it does to the ratio, and says what it costs this business.
When the ratio is too high: A current ratio far above 2 can be a problem too. Cash sitting in the bank earns almost nothing, and stock piled up in a store costs money to keep.
Then the strategy runs the other way: spend or return the spare cash
- Put it towards the $45,000 deck oven planned for Mill Lane in 2026.
- Pay off part of its loan.
- Pay a dividend.
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How this comes up: A table of a business's figures comes first, then a few short tasks.
The tasks
- Calculate the current ratio, showing all your working, for two marks.
- Calculate the working capital, for two.
- Comment on the business's liquidity, for two: say whether it can pay its short-term debts and back it with the ratios or the stock.
Or from a table of ratios: From a table of ratios over several years, comment on the liquidity position, or explain one reason why fast-growing sales have weakened liquidity.
The pattern for a comment on liquidity
- Work out the ratios first, correctly, in the margin: current ratio and acid test.
- Say what they mean for paying the bills: can the business meet its short-term debts, with or without selling stock?
- Add one point of depth from the case: how much is tied up in stock, how little is cash, or how the business gets its cash (sales at the till, customers on credit).
Two traps
- Numbers with no comment. 'The current ratio is 1.33 and the acid test is 1.08' says nothing about liquidity. The question wants what the numbers mean.
- A wrong ratio, then a comment on it. The comment is only as good as the arithmetic under it. Check that current assets are on top and that the stock came out of the acid test.
Comment on Lena's Bakery Ltd's liquidity at 31 December 2025.
Model answer plan
See the answer broken into clear points, with guidance on how each point earns marks.