Liquidity ratios

Learning objective

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

• Calculate key accounting ratios related to liquidity
• Interpret liquidity ratios against benchmarks and over time
• 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 assets and current liabilities 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:

$$\text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}$$

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:

$$\text{Quick ratio}=\frac{\text{Current assets}-\text{Inventory}}{\text{Current liabilities}}$$

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. A common rule of thumb is a quick ratio of about 1:1. Businesses that sell their inventory quickly, such as supermarkets, often operate safely below this.

Pitfall: Only inventory is removed from current assets for the quick ratio - trade receivables and prepaid expenses stay in the numerator, since they’re still expected to convert to cash within the normal operating cycle. If a company has a bank overdraft, remember it’s a current liability (not a reduction of cash), so it belongs in the denominator.

Interpreting liquidity results: A low current or quick ratio can point to overtrading, financing non-current assets with short-term borrowing, slow collection from trade receivables, or a build-up of inventory. A high ratio can mean idle cash or excess inventory and receivables tying up working capital instead of generating returns. Common remedies include chasing trade receivables, reducing inventory levels, converting short-term borrowing into long-term finance, or raising new equity.

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 statement of financial position has been provided for your analysis:

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
Trade receivables	119,808.00
Prepaid expenses	5,800.00
Cash at bank	45,200.00
Total current assets		265,008.00
Total assets		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:
Trade 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?

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. You may also be asked to compare the same company’s ratios across two years - the same formulas and the causes and remedies discussed above still apply.