2.3.2 - Liquidity

Reading liquidity from the statement of financial position

The statement of financial position is a snapshot of a business at one moment in time. For liquidity, the key sections are current assets and current liabilities, because they show the short-term resources available and the short-term debts that must soon be paid.

Current assets are assets likely to be turned into cash within 12 months, such as inventories, trade receivables and cash itself. Current liabilities are debts that must be repaid within one year, such as trade payables, tax liabilities and short-term borrowing. If current assets are too low compared with current liabilities, the business can face a cash squeeze even if sales are strong.

That is why liquidity should not be confused with profit. A business may make sales on credit, so revenue is recorded, but the cash has still not arrived. Equally, money can be tied up in inventories that have not yet been sold. Because bills must be paid on time, managers care about how quickly resources can turn into cash, not just whether the business appears valuable overall.

Measuring liquidity with ratios

Managers often turn the statement of financial position into ratios because ratios make short-term financial strength easier to compare. The two key measures are the current ratio and the acid test ratio.

The current ratio gives a first view of whether short-term assets cover short-term debts. However, not every current asset is equally easy to use. Inventories may take time to sell, so a business can look safer on the current ratio than it really is.

The acid test ratio is therefore a stricter measure because it removes inventories and focuses on assets that are nearer to cash. In exam answers, students often use around 1.5:1 as a rough guide for the current ratio and around 1:1 for the acid test ratio, but these are only starting points. The right figure depends on the business model, the speed of stock turnover and how much supplier credit the firm receives.

This short example shows why both ratios matter.

Here, the current ratio is 80 / 50 = 1.6:1. On the surface, that looks reasonably comfortable. But the acid test ratio is (80 - 40) / 50 = 0.8:1, which means the business has only 80p of near-cash current assets for every £1 of short-term debt. Because so much of its current assets are tied up in inventory, it may still struggle if stock does not sell quickly.

Working capital and the importance of cash

Working capital shows how much short-term finance is left for the day-to-day running of the business. The key calculation is simple: working capital = current assets - current liabilities. If this figure is too low, managers can quickly run into operational problems, because cash is needed before many benefits from sales are actually received.