💧 What is Liquidity?
Definition: Liquidity is the ability of a business to meet its short-term debts as they fall due. In simple terms: can the business pay its bills on time?
A business can be profitable but still fail if it doesn't have enough liquid assets (cash or near-cash) to pay suppliers, staff and other short-term obligations.
Liquidity ≠ Profitability. A profitable business can be illiquid, and a loss-making business can temporarily have plenty of cash! 💡
📊 Current Ratio
Formula: Current ratio = Current assets ÷ Current liabilities
The current ratio measures whether the business has enough current assets to cover its current liabilities. The result is expressed as a ratio (e.g. 2:1).
Example: Current assets = $60,000. Current liabilities = $30,000. Current ratio = $60,000 ÷ $30,000 = 2:1 This means the business has $2 of current assets for every $1 of short-term debt.
- Ideal range: 1.5:1 to 2:1 — enough to pay debts with a safety buffer
- Below 1:1 — danger! The business cannot cover its short-term debts
- Much above 2:1 — may mean too much cash sitting idle (inefficient)
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🧪 Acid Test Ratio (Quick Ratio)
Formula: Acid test ratio = (Current assets − Stock) ÷ Current liabilities
The acid test is a stricter version of the current ratio. It removes stock (inventory) because stock may be hard to sell quickly and therefore isn't truly 'liquid'.
Example: Current assets = $60,000. Stock = $20,000. Current liabilities = $30,000. Acid test = ($60,000 − $20,000) ÷ $30,000 = 1.33:1
- Ideal: around 1:1 — can pay debts without relying on selling stock
- Below 1:1 — the business relies on selling stock to pay its debts (risky)
- Well above 1:1 — very safe but possibly holding too much cash
Supermarkets often have acid test ratios well below 1:1 — and that's fine because they sell stock quickly for cash every day! Context matters 🛒
🔧 How to Improve Liquidity
If liquidity ratios are too low, the business needs to increase current assets or reduce current liabilities.
- Collect debts from customers faster (reduce receivables)
- Negotiate longer payment terms with suppliers
- Sell off excess stock quickly (even at a discount)
- Inject new capital (owner's funds or new shares)
- Arrange a short-term loan or overdraft facility
- Reduce unnecessary spending to conserve cash
Improving liquidity is about getting cash IN faster and pushing cash OUT slower — it's all about timing! ⏰
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🔢 Worked Example
FreshFoods Ltd Current assets: Stock $25,000 | Receivables $15,000 | Cash $5,000 = $45,000 Current liabilities: $30,000
Current ratio = $45,000 ÷ $30,000 = 1.5:1 ✓ Acceptable Acid test = ($45,000 − $25,000) ÷ $30,000 = 0.67:1 ⚠️ Below 1:1
Interpretation: The current ratio looks healthy, but the acid test reveals that without selling stock, FreshFoods cannot cover its debts. It is heavily reliant on inventory — this could be a problem if stock doesn't sell.
Always calculate BOTH ratios — a healthy current ratio can hide a weak acid test if the business holds a lot of stock! 🔍