Understanding liquidity and gearing ratios is essential in evaluating a business's short-term financial health and long-term financial risk. These ratios help stakeholders assess how effectively a business manages its finances and capital structure.
Liquidity Ratios
Liquidity refers to the ability of a business to meet its short-term financial obligations as they become due. Liquidity ratios focus on the relationship between a firm’s current assets and current liabilities to determine whether it can pay its immediate debts. Strong liquidity means a company is less likely to default on its obligations and more likely to maintain good relationships with creditors, suppliers, and investors.
Current Ratio
Definition:
The current ratio is one of the most widely used liquidity ratios. It measures whether the business has enough short-term assets to cover its short-term liabilities. It is a simple measure of financial health in the short term and gives a quick view of the firm’s working capital position.
Formula:
Current ratio = Current assets / Current liabilities
Explanation of Components:
Current assets are assets expected to be converted into cash within one year. This typically includes:
Cash and cash equivalents
Inventory
Trade receivables (money owed by customers)
Short-term investments
Current liabilities are obligations due within one year. This includes:
Trade payables (money owed to suppliers)
Short-term borrowings
Accrued expenses
Taxes payable
Purpose of the Ratio:
The current ratio shows the firm’s ability to meet its short-term obligations using its short-term assets. A ratio of 1 or more suggests the business can meet its short-term debts, while a ratio under 1 could signal financial difficulties.
Typical Interpretations:
Less than 1.0: The business may not have enough short-term assets to cover its short-term liabilities, indicating possible liquidity problems.
Between 1.5 and 2.0: Considered ideal for most industries — it shows good liquidity without excessive unused current assets.
Above 2.0: While this may appear safe, it could indicate that the company is holding too much idle current asset (like cash or stock), which could be used more effectively elsewhere.
Example:
A business has current assets of £300,000 and current liabilities of £150,000.
Current ratio = 300,000 / 150,000 = 2.0
This means the business has £2 in assets for every £1 in liabilities.
Factors Affecting Ideal Ratio:
Industry differences: For example, supermarkets operate with relatively low current ratios due to fast inventory turnover and strong cash flow.
Business cycle: Seasonal businesses may show high current assets at peak times.
Credit policy: Generous credit terms may increase receivables, inflating current assets.
Limitations of the Current Ratio:
It treats all current assets as equally liquid, though inventory is much less liquid than cash.
It does not consider the timing of inflows and outflows — a company might have enough assets on paper but still struggle with cash flow if receivables are slow to collect.
It offers no insight into the quality of current assets — receivables could be overdue, or inventory may be obsolete.
Gearing Ratios
Gearing refers to the proportion of a company’s capital that comes from debt. A gearing ratio assesses the extent to which a business is financed through borrowed money versus shareholders’ equity. It is a vital measure of financial risk and is particularly important when assessing the long-term solvency and stability of a business.
Gearing Ratio
Definition:
The gearing ratio expresses non-current liabilities as a percentage of capital employed. It helps stakeholders assess the financial leverage of a business.
Formula:
Gearing ratio = (Non-current liabilities / Capital employed) × 100
Explanation of Components:
Non-current liabilities include:
Long-term bank loans
Debentures
Other long-term borrowings that are not due within one year
Capital employed is the total amount of capital used to generate profits and includes:
Shareholders' equity (share capital + retained earnings)
Non-current liabilities
Purpose of the Ratio:
The gearing ratio tells us how reliant a business is on debt as opposed to equity to finance its operations. High gearing means higher financial risk due to the obligation to make interest payments and repay debt.
Typical Interpretations:
Below 25%: Low gearing — the business is mainly financed through equity. This indicates low financial risk and may appeal to conservative investors.
Between 25% and 50%: Moderate gearing — a balanced capital structure that provides some financial leverage without excessive risk.
Above 50%: High gearing — a large proportion of the firm’s capital is financed through debt, which can increase returns but also risk.
Example:
A business has non-current liabilities of £400,000 and shareholders’ equity of £600,000.
Capital employed = 400,000 + 600,000 = £1,000,000
Gearing ratio = (400,000 / 1,000,000) × 100 = 40%
This indicates moderate gearing, suggesting balanced use of debt and equity.
Significance of Gearing:
High gearing means higher interest payments and fixed costs, which can reduce net profits and cash flow.
Low gearing may indicate under-utilisation of debt, potentially missing opportunities to grow through expansion or investment.
Risks of High Gearing:
Greater financial pressure in economic downturns when cash flow may be tight.
Increased vulnerability to interest rate rises.
Possible reduction in creditworthiness, making further borrowing more expensive or difficult.
Strain on cash flow due to required interest payments.
Risks of Low Gearing:
May signal overly cautious financial management.
Potentially inefficient capital structure if the firm avoids low-cost debt financing.
Missed opportunities for business growth and expansion.
Industry Context:
Industries like utilities or construction may operate successfully with higher gearing due to predictable cash flows and asset bases.
Service-based firms with limited physical assets often maintain low gearing to stay flexible.
Using Liquidity and Gearing Ratios Together
These ratios should not be assessed in isolation. Combining them gives a fuller picture of a business’s financial position — short-term stability and long-term resilience.
Comparative Analysis:
A business may appear stable from a liquidity perspective but carry significant long-term debt.
Alternatively, a low-geared business might struggle with liquidity if it cannot convert current assets into cash quickly.
Example 1:
Company A
Current ratio: 2.2
Gearing ratio: 65%
Interpretation: Strong short-term liquidity but heavy reliance on debt — potentially risky if interest rates rise or income drops.
Example 2:
Company B
Current ratio: 0.8
Gearing ratio: 20%
Interpretation: Low long-term debt risk but possibly unable to meet short-term liabilities — may indicate poor working capital management.
Trends Over Time:
A rising gearing ratio may indicate increasing dependence on debt — potentially risky if profits don’t grow accordingly.
A declining current ratio over time might reflect deteriorating liquidity, signalling issues with receivables, stock management, or rising short-term debts.
Ideal Ranges and Strategic Implications
Ideal Current Ratio:
Between 1.5 and 2.0 is commonly viewed as healthy.
Allows a comfortable buffer without tying up excessive capital in low-return assets.
Too Low:
May alarm investors and creditors.
Could lead to issues in securing short-term finance or trade credit.
Too High:
May suggest poor asset utilisation.
Unproductive use of capital — cash and inventory could be better invested or used to reduce liabilities.
Ideal Gearing Ratio:
A range of 25% to 50% is generally sustainable for many firms, though this varies by sector.
Over-Gearing Risks:
Loss of control if creditors impose restrictive loan covenants.
Potential dilution of shareholder value if equity is issued to reduce debt later.
Bankruptcy risk if cash flows cannot sustain interest and principal repayments.
Under-Gearing Risks:
Opportunity costs — the business could have used borrowing to invest in profitable ventures.
May limit growth if internal finance and equity cannot fund expansion plans.
External Factors That Influence Ideal Ratios:
Interest rates: Low rates encourage more debt as borrowing is cheaper.
Economic conditions: During uncertainty, investors and creditors favour conservative, low-geared firms with strong liquidity.
Business strategy: Aggressive growth strategies often involve higher gearing, while mature companies may favour lower gearing for stability.
Final Notes on Interpretation:
Ratio values should be compared:
Over time — to identify trends and changes.
Against industry benchmarks — to assess relative performance.
Ratios must be viewed in context — they are tools to aid judgement, not absolute indicators.
Financial statements and ratios reflect historical data and may not capture sudden market shifts, qualitative factors (like leadership or brand strength), or forward-looking performance.
FAQ
A high current ratio, such as above 2.0, might suggest strong liquidity on the surface, but it can be misleading. If a large portion of the current assets is tied up in slow-moving or obsolete inventory, or if receivables are overdue, the business may struggle to convert these into cash quickly enough to meet immediate obligations. Additionally, timing mismatches between when cash is received and when liabilities are due can create liquidity gaps despite a favourable ratio.
A business can improve its current ratio by boosting its current assets. This could include accelerating receivables collection through stricter credit terms or offering early payment discounts. Reducing inventory levels to optimal levels using just-in-time systems or improving sales can also help. Selling underutilised non-current assets for cash or delaying discretionary expenses like marketing spend can also increase cash holdings. These strategies improve liquidity without increasing reliance on short-term or long-term borrowing.
Capital structure refers to the mix of debt and equity financing. If a business takes on more long-term debt, its non-current liabilities rise, increasing the gearing ratio. Conversely, issuing new shares increases equity, which dilutes the proportion of debt and reduces the gearing ratio. Repaying existing debt with retained earnings or raising capital through equity issuance will also lower gearing. Therefore, any decision involving debt or equity significantly influences the business’s financial risk profile through its impact on gearing.
A high gearing ratio may be strategically advantageous if interest rates are low and the business can borrow cheaply to invest in growth opportunities, such as expansion or new product development. If these investments generate higher returns than the cost of debt, profitability and shareholder value can increase. High gearing is also useful in capital-intensive industries like construction or transport, where consistent cash flows can service debt. However, it must be carefully managed to avoid financial strain if conditions change.
Some businesses prefer low gearing to maintain financial flexibility and minimise exposure to debt-related risk. For example, companies in unpredictable markets or those with volatile earnings may avoid high debt to prevent being overburdened during downturns. Retained profits can fund operations and growth without the pressure of regular interest payments. Additionally, maintaining low gearing can improve credit ratings, reduce borrowing costs, and signal stability to investors, making the business more attractive for long-term investment.
Practice Questions
Analyse the implications of a business having a current ratio of 0.8.
A current ratio of 0.8 suggests that the business has only 80p of current assets for every £1 of current liabilities, indicating potential liquidity problems. This may lead to difficulties in paying short-term obligations, damaging supplier relationships and possibly reducing credit terms. Investors and creditors could view the business as financially unstable, increasing the cost of borrowing. However, the implications depend on industry norms; some businesses operate effectively with low liquidity. Management may need to improve working capital, such as reducing inventory or speeding up receivables, to ensure adequate short-term financial resilience and protect operational continuity.
Evaluate the use of the gearing ratio when assessing the long-term financial health of a business.
The gearing ratio is valuable in assessing how much of a business’s capital structure is funded by debt, highlighting long-term financial risk. High gearing suggests greater exposure to interest rate rises and financial obligations, which can threaten solvency if earnings fall. However, gearing can also enhance returns if borrowed capital is used productively. Its usefulness is limited without context — comparisons over time and against industry averages are essential. It also overlooks qualitative factors such as leadership or market position. Therefore, while gearing provides useful insights, it should be combined with other indicators to fully assess financial health.
