Liquidity ratios

Learning objective

By the end of this module, you should be able to:

• Calculate key accounting ratios related to liquidity
• Calculate and interpret the relationship between the elements of the financial statements regarding profitability, liquidity, efficient use of resources, and financial position.
• Draw valid conclusions from the information contained within the financial statements and present these to the appropriate user of the financial statements.

Definitions

Liquidity ratios

These ratios measure a company’s ability to generate enough cash (or near-cash resources) in the short term to meet obligations as they fall due. They focus on the relationship between current asset and current liability figures from the statement of financial position.

This group of ratios includes:

• Current ratio
• Quick ratio

Current ratio

This is a short-term measure of a company’s liquidity position. It’s designed to show whether the company has enough short-term assets to cover its short-term liabilities.Formula:

$$\text{Current Ratio}=\frac{\text{Current Asset}}{\text{Current Liabilities}}$$

Interpretation: A common rule of thumb is that current assets should be about twice current liabilities. A current ratio significantly below two (2) may signal liquidity pressure, meaning the company could struggle to pay short-term debts when due. A ratio above 2 suggests the company can cover short-term obligations comfortably, but it may also indicate that too much money is tied up in inventory or other current assets instead of being invested more productively. The “ideal” ratio varies by industry, and some industries operate safely with ratios below 2.

Quick Ratio (Acid Test Ratio)

This ratio measures how easily a company can meet current obligations using quick assets - current assets that can be converted into cash quickly. It excludes inventory because inventory is generally less liquid and may take time to sell.Formula:

$$\text{Quick Ratio}=\frac{\text{Current Asset}-\text{Inventory}}{\text{Current Liabilities}}$$

Interpretation: Comparing the quick ratio to the current ratio helps you see how much inventory affects liquidity. If both ratios increase, but the current ratio increases more than the quick ratio, it often suggests the company has been building up inventory.

Illustration: Financial statement analysis

Sokoto Company Limited is a manufacturing company that has been operating for several years. The company’s financial controller has prepared the financial statements for the year ended 31 December 2024. As a financial analyst, you have been asked to evaluate the company’s performance for the period.

The following financial statements have been provided for your analysis:

Statement of profit or loss and other comprehensive income

	$
Sales revenue	935,200.00
Cost of Sales	(442,300.00)
Gross Profit	492,900.00
Distribution cost	(151,000.00)
Administrative expenses	(213,192.00)
Profit before interest and tax	128,708.00
Finance expense	(16,000.00)
Profit before Tax	112,708.00
Income tax for the year	(51,600.00)
Profit after tax	61,108.00
Other Comprehensive Income
Revaluation Surplus	50,000.00
Total comprehensive income	111,108.00

Statement of financial position as at 31 December 2024

	$	$
Non-current Asset:
Property, Plant and Equipment		522,800.00
Current Asset:
Inventories	94,200.00
Accounts receivables	119,808.00
Prepaid expenses	5,800.00
Cash at bank	45,200.00
Total Current Assets		265,008.00
Total Asset		787,808.00
EQUITY AND LIABILITIES
Equity:
Ordinary share capital (50,000 shares)	200,000.00
Retained earnings	189,508.00
Revaluation Surplus	50,000.00
Total Equity		439,508.00
Non-current Liabilities:
8% Debenture		200,000.00
Current Liabilities:
Account Payables	83,300.00
Accrued expenses	16,400.00
Income tax payable	48,600.00
Total Current Liabilities		148,300.00
Total Equity and Liabilities		787,808.00

Ratio	Industry average
Current ratio	1.5
Quick ratio	1.0

Required: Calculate the following liquidity ratios for Sokoto Company Limited for the year ended 31 December 2024:

a. Current ratio

b. Quick ratio

c. Compare each of your calculated ratios with the industry average provided above and comment on Sokoto Company Limited’s performance relative to the industry.

Suggested solution:

Make sure you try calculating and making the comparisons by yourself before reviewing the suggested solution below.

1. What is the current ratio?

2. What is the quick ratio?

Summary table of the analysis

Ratio	Company result	Industry average	Interpretation
Current Ratio	1.79	1.5	Strong ability to meet short‑term obligations; healthy working capital.
Quick Ratio	1.15	1.0	Can cover immediate liabilities without relying on inventory; good short-term liquidity.

Overall assessment: Both liquidity ratios are above the industry averages, so Sokoto Company Limited appears more liquid than the typical manufacturing firm in 2024. While very high liquidity ratios can sometimes suggest that too much money is tied up in current assets, these results are only moderately above the benchmarks.

The difference between the current ratio (1.79) and the quick ratio (1.15) is 0.64. This gap reflects the effect of inventory on liquidity. For a manufacturing company, this is generally expected and suggests inventory levels are meaningful but not unusually high relative to current liabilities.

Note: This question only performed an industry-level comparison. However, you may be given information for the same company for two (2) different years for a similar comparison. All you need is knowing the formulas and being able to interpret the results in terms of whether it is a good or bad performance, and factors that may have contributed to such results, as well as what could be done to improve the results.