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Current and Acid Test Ratio

As we know a firm has to have sufficient liquidity. In other words they have to be able to meet their day to day payments. It is no good having your money tied up or invested so that you haven't enough to meet your bills! Current assets and liabilities are an important part of this liquidity and so to measure the firms liquidity situation we can work out a ratio. It is called the CURRENT RATIO.

The current ratio is worked out by dividing the current assets by the current liabilities:-

CURRENT RATIO = Current assets

Current liabilities

This figure should always be above 1 or the firm does not have enough assets to meet its liabilities and is therefore technically insolvent. However, a figure close to 1 would be a little close for the firm as they would only just be able to meet their liabilities and so a figure of between 1.5 and 2 is generally considered to be desirable. A figure of 2 means that they can meet their liabilities twice over and so is safe for them. If the figure is any bigger than this then the firm may be tying up too much of their money in a form that is not earning them anything. If the current ratio is bigger than 2 they should therefore perhaps consider investing some for a longer period to earn them more.

However, the current assets also include the firm's stock (see current assets for more detail on them). If the firm has a high level of stock, it may mean one of two things:-

  1. Sales are booming and they're producing masses to keep up with demand
  2. They can't sell all they're producing and it's piling up in the warehouse!


If the second of these is true then stock may not be a very useful current asset, and even if they could sell it it isn't as liquid as cash in the bank, and so a better measure of liquidity is the ACID TEST (or QUICK) RATIO. This excludes stock from the current assets, but is otherwise the same as the current ratio.

ACID TEST RATIO = Current assets - stock

Current liabilities

Ideally this figure should also be above 1 for the firm to be comfortable. That would mean that they can meet all their liabilities without having to sell any of their stock. This would make potential investors feel more comfortable about their liquidity. If the figure is far below 1 they may begin to get worried about the firm's ability to meet its debts.


Source:
http://www.bized.co.uk
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