CHAPTER 8 Analysis and interpretation of financial statements 3418.6 Liquidity analysis
LEARNING OBJECTIVE 8.6 Define, calculate and interpret the ratios that measure liquidity.
An entity’s inability to pay its debts when they fall due can result in creditors taking legal action against
the entity to recover their monies. The survival of the entity therefore depends on its ability to pay its
debts when they fall due. This ability to discharge short-term cash flow obligations is referred to as
an entity’s liquidity. A number of ratios can be calculated to determine an entity’s liquidity. Because
liquidity is a measure of events over the short term, the ratios concentrate on an entity’s current assets
and current liabilities. The excess from current assets and current liabilities is referred to as an entity’s
working capital. An entity must have sufficient working capital to satisfy its short-term requirements
and obligations. However, excess working capital is undesirable because the funds could be invested in
other assets that would generate higher returns.
Current ratio and quick ratio
The current ratio and quick ratio are commonly used to assess an entity’s liquidity position. The ratios
are calculated as follows.
Current ratio:
Current assets
=x times
Current liabilitiesQuick ratio:
Current assets − inventory
=x times
Current liabilitiesThe current ratio (also referred to as the working capital ratio) indicates the dollars of current
assets the entity has per dollar of current liabilities. It is undesirable to have a ratio that is too low, as this
suggests that the entity will have difficulty in meeting its short-term obligations. However, a high cur-
rent ratio is not necessarily good, as it could be due to excess investments in unprofitable assets — cash,
receivables or inventory.
The quick ratio (also referred to as the acid-test ratio) measures the dollars of current assets avail-
able (excluding inventory) to service a dollar of current liabilities. It is a more stringent test of liquidity,
as it excludes current inventory from the numerator. Inventory is excluded because it is the current asset
that takes the longest period of time to convert to cash.
The difference between the current and quick ratios will be significant for manufacturing and retail
entities with large inventory holdings, but insignificant for entities that are in service-related industries.
When assessing the current ratio, an arbitrary rule of thumb is that it should be around $1.50 of current
assets for every $1 of current liabilities. The arbitrary benchmark ratio for the quick ratio is around $0.80 of
current assets (excluding inventory) for every $1 of current liabilities. In calculating the quick ratio, bank over-
drafts can be deducted from the denominator. This is done in recognition that bank overdrafts are permanent
sources of funding to an entity, but are classified as current because they are repayable on demand. Similarly,
prepayments can be deducted from the numerator because they will not produce a cash inflow. A ratio that is
higher (lower) than the arbitrary ratios should not be interpreted as a positive (negative) signal. The adequacy
of the liquidity ratios needs to be assessed in conjunction with the entity’s activity cycle. A short activity cycle
will support a lower level of liquidity, whereas a longer activity cycle will require more liquidity.
Cash flow ratio
Another ratio that helps to assess liquidity is the cash flow ratio. Based on net cash flows from operating
activities, the cash flow ratio indicates an entity’s ability to cover its current obligations from operating
activity cash flows. The higher the ratio, the better the position of the entity to meet its obligations. It is