liquidity ratios are used to measure a business's ability to pay off its
short-term obligations, this video identifies two liquidity ratios. first
being the current ratio and the second the liquid capital ratio, also known as
the acid test ratio. We will look at where to find the information for these
ratios on a statement of financial position, how to calculate these ratios
and finally what they tell us about the business.
The first thing we're going to look at is why liquidity ratios are used. A
business uses liquidity ratios to assess its ability to meet short-term financial
obligations. They're of particular interest to those who may be providing
short-term credit to the firm. The ratios will show how easily the business will
be able to repay its debt. There are two ratios that are commonly used to analyse
the liquidity of a business. The first is the current ratio and the second the
liquid capital ratio, also known as the acid test or quick ratio. The information
used to calculate the liquidity ratios can be found on a businesses statement
of financial position. Lets have a quick look at the key elements of a
statement of financial position and what information is needed to calculate
liquidity ratios. This is a statement of financial position for business zed. In
order to calculate liquidity ratios it's important that you know what to look for
on a statement of financial position also known as a balance sheet. The
information needed for the statement of financial position are as follows;
current assets which is shown here, current liabilities and your inventory
these are the three things needed to calculate both ratios. Pause the video if
needed to familiarise yourself with the statement of financial position. We only
need these three bits of information to calculate the current ratio and liquid
capital ratio for business zed. The first liquidity ratio we're going to calculate
using the information from the statement of financial position is a current ratio,
the current ratio is calculated by dividing your current assets by your
current liabilities and provides you with a ratio and shows a relationship
between the two, both can be found in a statement of financial position
discussed in the previous slide. If current assets are greater than current
liabilities then this means the business is in a healthy shape and it has the
ability to pay back in a short term financial commitments, however if the
ratio is less than one to one then this indicates that the business has less
current assets than it has current liabilities and therefore may struggle
to repay these short-term obligations. Using the information from the previous
balance sheet let's put some numbers to this formula.
The business has current assets of a hundred and seventy five thousand pounds
and current liabilities of a hundred forty thousand pounds when you divide
these following the current ratio formula you get an answer of 1.25 to 1
therefore this shows that the business has 1.25 current assets for every one
liability meaning that the business has enough current assets to cover its short
term financial obligations, putting it in a relatively healthy position. The second
ratio is the liquid capital also known as the acid test ratio this formula is
very similar to the current ratio however the key difference is that the
ratio excludes inventory than the business's current assets this is useful
to know as inventory takes time to sell and possibly could not be used
immediately to settle debts easily as cash could. The liquid capital ratio is
calculated in the following way; current assets minus inventory divided by current
liabilities this calculation is useful as it tells the business whether it
can meet short-term financial commitments, without having to sell
through its stock / inventory. In other words just cash and debtors are
measured as current assets. If you use the information from the previous
balance sheet then the calculation would look like this; current assets of 175
thousand pound minus 120 thousand pound inventory, this equals 55,000 pounds.
Divide that by a hundred and forty thousand which gives you nought point
three nine to one. This example shows that business Zed is illiquid as it has less
than half the amount of current assets excluding inventory to every liability,
meaning it could struggle to take short term financial obligations without the
sale of its inventory.So now we've calculated the current ratio and the
liquid capital ratio, let's interpret what these mean. The first thing you can do is
use it to make comparisons to competitors with an industry and also
investigate the liquidity trends from within the business year on year. The
current ratio for business said is 1.25 to 1
which shows that the business can meet any short-term financial obligations
problems may occur if the ratio is below one as it will indicate the business had
liquidity problems and therefore please put in place financial management
measures to resolve this. The current ratio can also be too high which could
show that that the business is sitting on too much cash that could be invested elsewhere
in the business to achieve a greater rate of return,
however 1.25 is a little on the low side but is still an acceptable figure. The
liquid capital ratio is a good indicator of true liquidity and it shows a more
realistic view as stock can take time to turn into cash and therefore may not be
truly liquid. Like the current ratio, any business with a liquid capital ratio
below 1 would indicate liquidity problems This is where business zed
fails miserably in terms of its liquidity as a liquid capital ratio sits
at 0.39 to 1, which shows the business has less than half
the amount of current assets to current liabilities. Such a drop in the liquid
capital ratio compared to the current ratio shows that the business is
holding a large amount of its current assets in stock. Thanks for watching and
I hope you have a better understanding of liquidity ratios and if you found
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