Liquidity ratios measure a business’s ability to meet short-term obligations from short-term resources. At this level, the key calculations are the current ratio and the acid test ratio, both drawn from statement of financial position figures.

Understanding liquidity

In accounting, liquidity refers to short-term financial strength.

Liquidity ratios use figures from the statement of financial position at a particular date.

This example balance sheet highlights the current assets section and shows how it sits above non-current assets, making it easier to locate the figures needed for liquidity ratios. It also shows the current liabilities subsection under liabilities, reinforcing that both numerator and denominator come from the same statement/date. Source

They indicate whether the business appears able to pay amounts due in the near future using assets expected to turn into cash within one year. A business may report profit but still have weak liquidity if cash is tied up in inventory or in amounts owed by customers.

Current ratio

One of the main liquidity measures is the current ratio.

This diagram summarizes the current (working capital) ratio as a comparison of current assets to current liabilities. It helps you remember the structure $\dfrac{Current\ Assets}{Current\ Liabilities}$ before you plug in statement of financial position totals. Source

It compares total current assets with total current liabilities and is sometimes called the working capital ratio.

Current assets normally include items such as inventory, trade receivables, cash at bank, cash in hand, and other short-term balances. Current liabilities normally include trade payables, accruals, short-term loans, tax payable, and bank overdrafts repayable in the short term.

The answer is usually presented as a ratio, such as $2.0:1$. This means the business has two units of current assets for every one unit of current liabilities. A figure above $1:1$ shows current assets exceed current liabilities, while a figure below $1:1$ shows the opposite. The ratio is a measure of short-term cover, not proof that cash is available immediately.

Acid test ratio

Another important liquidity measure is the acid test ratio, also known as the quick ratio.

This diagram illustrates the quick (acid test) ratio by showing that you start with current assets and remove less-liquid items before dividing by current liabilities. It reinforces the key idea in the formula $\dfrac{Current\ Assets-Inventory}{Current\ Liabilities}$ (and why excluding inventory makes the measure stricter). Source

This ratio gives a stricter view of liquidity than the current ratio.

Inventory is removed because it may not be sold quickly, and its sale value may not be realized immediately. As a result, the acid test ratio focuses more closely on assets that are nearer to cash, such as receivables and cash balances.

The acid test ratio is usually lower than the current ratio because the numerator is smaller once inventory has been excluded. If a business holds little inventory, the two ratios may be quite similar. The answer can be shown as a ratio such as $1.1:1$.

Selecting the correct figures

To calculate either ratio correctly, use figures from the same date. Do not mix opening balances with closing balances, and do not combine figures from different statements.

If a question gives total current assets and current liabilities, substitute those totals directly into the formula. If separate items are given, identify whether each item is current or non-current before calculating.

For the acid test ratio, subtract inventory once only. If a question already provides quick assets or liquid assets, use that amount as the numerator without removing inventory again.

Amounts due after more than one year are not included in current liabilities, and non-current assets are never included in the liquidity ratio numerators.

Presenting answers clearly

In examination answers, clear presentation matters.

Good practice

• write the correct formula first if space allows

• show the figures used in the numerator and denominator

• simplify the result to a ratio in the form $x:1$

• keep a sensible level of accuracy, often one or two decimal places

• label the answer as current ratio or acid test ratio

A ratio on its own is not enough if the examiner cannot see which measure you have calculated.

Common mistakes

• reversing the formula and dividing current liabilities by current assets

• including non-current assets such as equipment or buildings

• forgetting to exclude inventory from the acid test ratio

• subtracting inventory when the question has already given quick assets

• omitting short-term obligations from current liabilities

• treating liquidity as exactly the same as cash in hand

These errors usually come from weak classification rather than difficult arithmetic.