Page 291 - Cambridge IGCSE Business Studies

23: Analysis of accounts

As a general rule the current ratio must be no less than 1.5:1 – otherwise there is
a risk of running out of cash. It should be no greater than 2:1 – since this suggests
that the business has too much cash tied up in unprofitable assets. However, there

are other factors that can influence a business’s ability to access cash quickly such

as overdraft facilities and sale of unwanted assets.
Acid test ratio

The main problem with the current ratio as a measure of liquidity is that some

current assets are more difficult to turn into cash than others. Inventories are the

least liquid of the current assets because:
■ the finished goods inventories have to be sold
■ when they are sold on credit, the business has to wait for customers to pay.

KEY TERM Th e acid test ratio excludes inventories from current assets. It shows the most
liquid current assets as a ratio of current liabilities. For this reason the acid test
Acid test ratio: ratio between ratio is often considered to be a better measure of a business’s liquidity.

liquid assets and current
liabilities. (current assets inventories)−
Acid test ratio =
current liabiilities

EXAMPLE

Using the data from Table 23.4, the 2012 acid test ratio for TT is: 289
(60 – 20)
Acid test ratio (2012) =
40
= 1 : 1

An acid test ratio of 1:1 is generally satisfactory. If it is lower than this there is a risk
of the business not having enough cash to pay its short-term liabilities. If it is too
high then cash is being tied up in unprofi table assets.

ACTIVITY 23.5

Copy out the table below.

2012 2013

Current ratio 1.5:1
Acid test ratio 1:1

1 Using the data in Table 23.4 calculate the liquidity ratios for 2013.
2 Using your results, comment on the liquidity position of TT in 2013 compared to 2012.
3 Explain two ways of improving TT’s liquidity.