Liquidity Ratios

Current ratio = current assets ÷ current liabilities = 110,000 ÷ 55,000 = 2:1.

Current assets − inventory = (35,000 + 25,000 + 5,000) − 35,000 = 30,000. Acid test = 30,000 ÷ 50,000 = 0.6:1.

Current assets = 48,000 + 36,000 + 6,000 = 90,000. Current liabilities = 40,000 + 20,000 = 60,000. Current ratio = 90,000 ÷ 60,000 = 1.5:1. Acid test = (90,000 − 48,000) ÷ 60,000 = 42,000 ÷ 60,000 = 0.7:1.

The current ratio (1.8:1) is above 1:1, suggesting that, overall, the business has enough current assets to cover its current liabilities.

However, the acid test ratio (0.6:1) is well below 1:1: if the business had to pay its current liabilities without selling inventory, it could cover only 60 cents in every $1 owed.

The large gap between the two ratios shows that a high proportion of its current assets is tied up in inventory. This is a liquidity concern: if creditors demanded quick payment or the inventory proved slow to sell, the business could struggle to meet its short-term obligations. It should consider reducing inventory and collecting receivables faster to improve the acid test position.

How it can arise. Profit is measured on an accruals basis (income less expenses) and is not the same as cash. A business can be profitable but short of cash if:

• it sells on credit and collects slowly (cash tied up in receivables);
• it holds large amounts of inventory (cash tied up in stock);
• it pays suppliers quickly (cash leaves fast).

So its profit may be locked up in receivables and inventory rather than available as cash, which is why the acid test (0.5:1) is so low — it can cover only half its short-term liabilities without selling stock.

The danger. If the business cannot pay its suppliers, wages or loan repayments as they fall due, creditors may refuse further supply, charge interest, or take legal action, and ultimately the business could be forced to stop trading — failing despite being profitable.

Conclusion. This shows that liquidity, not just profitability, determines survival. The business urgently needs to free up cash — collect receivables faster, reduce inventory, slow (within terms) its payments, and consider long-term finance — to avoid a cash crisis.

1. Collect receivables faster. Tighter credit control (chasing debts, settlement discounts, credit limits) brings cash in sooner, raising the acid test. Drawback: settlement discounts reduce profit, and very tight terms could lose customers.

2. Reduce inventory. Selling slow-moving stock and ordering less frees up cash. Drawback: cutting inventory too far risks stock-outs and lost sales.

3. Negotiate longer supplier credit / raise long-term finance. Paying suppliers a little later (within terms) slows cash out; or raising a long-term loan or share capital funds working capital without relying on an overdraft. Drawback: paying too slowly risks supplier goodwill, and extra finance brings interest or dilution of control.

Conclusion. Each measure speeds cash in or slows cash out and would improve the ratios, but the business should aim for a balanced working-capital position rather than maximising the ratios at the expense of sales, supplier relationships or extra cost.

A current ratio of 3.5:1 is much higher than the usual guide of around 2:1, meaning current assets are far greater than current liabilities. While this looks 'safe', it may indicate inefficient use of resources:

• the business may be holding too much inventory (slow-moving, tying up cash and risking obsolescence);
• it may have too many receivables (collecting too slowly); or
• it may be holding excessive idle cash that earns little.

These resources could be put to more productive use — for example reinvested in the business to earn a return. So a very high current ratio can signal that working capital is being managed inefficiently, not just that the business is liquid.

The combination of rapidly rising sales with falling liquidity (current ratio 2:1 → 1.1:1) and a growing overdraft strongly suggests overtrading — the business is expanding faster than its working capital can support.

As sales grow, the business needs more inventory and gives more credit to customers, which ties up cash. If its working capital and long-term finance do not grow with sales, it relies increasingly on its overdraft, and its liquidity falls. Eventually it may be unable to pay suppliers, wages or interest as they fall due — a cash crisis despite growing sales.

What it should do:

• Raise additional long-term finance (a loan or share capital) to fund the higher level of trading, rather than relying on an overdraft;
• manage working capital carefully — tighten credit control, control inventory, and slow (within terms) supplier payments;
• possibly slow the rate of expansion to a level its finances can sustain.

Conclusion. The signs point to overtrading; the business should secure adequate long-term finance and tighter working-capital control before its liquidity worsens further.

Inventory is the least liquid current asset: before it becomes cash it must first be sold and then (if sold on credit) the cash collected. The acid test therefore excludes it to show whether the business can pay its short-term debts without relying on selling inventory.

The change. Both ratios have fallen sharply — the current ratio from 2.0:1 to 1.3:1 and the acid test from 1.0:1 to 0.5:1 — so the business's liquidity has deteriorated significantly.

Significance. The acid test is now 0.5:1, meaning that without selling inventory the business can cover only half of its short-term liabilities. As the acid test has fallen more than the current ratio, a large part of the decline is due to a build-up of inventory (or a fall in cash/receivables). This is a serious concern: if suppliers or other creditors demanded prompt payment, the business could struggle to pay them, risking a cash crisis even if it is profitable.

Recommended measures (any two):

• Collect receivables faster — tighter credit control and settlement discounts — to bring in cash and raise the quick assets.
• Reduce inventory — clear slow-moving stock and order less — to free up cash.
• (Also: raise long-term finance to fund working capital instead of relying on an overdraft, or reduce drawings/dividends to retain cash.)

Conclusion. Liquidity has worsened to a worrying level, and the business should act — particularly on inventory and receivables — to restore its ability to meet short-term debts before it faces a cash shortage.