3.5.2 - Liquidity and comparisons

3.5.2 - Liquidity and comparisons

Learn why liquidity matters and how to compare it across years and businesses without overlooking payment timing, asset quality or different business models.

Why liquidity matters

Liquidity matters because payments must be met when they fall due, even if the business is profitable over the year.

Liquidity

The ability to meet short-term payments when they fall due.

A business needs cash to pay employees, suppliers, rent and other obligations. If an illustrative school-uniform shop sells on credit, it can record revenue and profit before parents or schools pay. Meanwhile, the fabric supplier may require cash now. Profit measures revenue less expenses for a period; liquidity concerns available cash and the timing of obligations.

Late supplier payment can lead to suppliers refusing further credit or deliveries. Without fabric, the shop may fail to fulfil orders, losing revenue and trust. Failure to pay wages can disrupt production. Persistent inability to meet debts threatens survival, so the consequences of poor liquidity extend beyond an uncomfortable balance in a bank account.

Holding more cash may improve resilience, but retaining excessive idle cash or unwanted inventory can sacrifice productive investment. Businesses need a suitable balance rather than the highest possible current ratio. Current and acid test ratios provide clues; a cash-flow forecast helps identify the dates on which shortages may occur.

Comparing previous years

Comparing ratios over time can reveal a trend, provided the dates and measurement bases are comparable.

The following data are illustrative for one retailer, using the same accounting policies at each 31 December. All amounts are in USD thousands; ratios have no currency unit.

Year-endCurrent assetsInventoryCurrent liabilitiesCurrent ratioAcid test ratio
20246020302.00:11.33:1
20257236401.80:10.90:1

For 2025, current ratio is 72/40=1.8072/40=1.80; acid test ratio is (72−36)/40=0.90(72-36)/40=0.90. For 2024, acid test is (60−20)/30=1.333…(60-20)/30=1.333\ldots, rounded to 1.33. Current assets rose, but current liabilities grew faster, so the current ratio fell. Inventory also increased, leaving a smaller cushion of assets excluding inventory relative to liabilities.

Current ratio=current assetscurrent liabilities\text{Current ratio}=\frac{\text{current assets}}{\text{current liabilities}} Acid test ratio=current assets−inventorycurrent liabilities\text{Acid test ratio}=\frac{\text{current assets}-\text{inventory}}{\text{current liabilities}}

Match dates and units; do not multiply these ratios by 100.

The pattern warrants investigation of payment dates and unsold goods; it does not prove the retailer has failed. The new inventory might be for confirmed January orders. Comparing a pre-holiday December snapshot with a quiet February would confuse seasonal conditions with a trend. Use consistent periods and, where possible, several years plus forecasts rather than assuming two snapshots guarantee the future. The current ratio fell by 0.20, not by 0.20 percentage points: a liquidity ratio is not a percentage.

Comparing other businesses

Ratios allow comparisons between different-sized businesses, but similar numbers can conceal different liquidity risks.

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