Liquidity ratios test whether a business can pay its short-term debts. The current ratio uses all current assets. The quick ratio removes stock.
This lesson follows calculating profitability ratios.
What are the formulas?
| Ratio | Formula |
|---|---|
| Current ratio | Current assets ÷ Current liabilities |
| Quick ratio | (Current assets − Closing stock) ÷ Current liabilities |
Give the answer as a ratio, such as 2 : 1, or as a number of times, as the question asks.
Worked example: sort first, then divide
Here is an original statement extract for a shop, in RM.
| Item | Amount |
|---|---|
| Equipment | 20 000 |
| Closing stock | 9 000 |
| Debtors | 6 000 |
| Bank | 3 000 |
| Creditors | 7 500 |
| Accrued expenses | 1 500 |
Step 1: sort. Current assets are stock, debtors and bank: 9 000 + 6 000 + 3 000 = 18 000. Equipment is non-current, so it stays out. Current liabilities are creditors and accrued expenses: 7 500 + 1 500 = 9 000.
Step 2: current ratio. 18 000 ÷ 9 000 = 2 : 1.
Step 3: quick ratio. (18 000 − 9 000) ÷ 9 000 = 9 000 ÷ 9 000 = 1 : 1.
The shop holds 2 of current assets for every 1 owed, and 1 of quick assets for every 1 owed. It can pay its short-term debts without selling any stock.
The mistake that costs marks
The slip is to keep stock in the quick ratio, or to include equipment in current assets. Both inflate the answer.
| Step | Wrong | Right |
|---|---|---|
| Quick ratio numerator | 18 000 (stock kept) | 9 000 (stock removed) |
| Quick ratio | 2 : 1 | 1 : 1 |
| Current assets | 38 000 (equipment added) | 18 000 |
The wrong quick ratio is identical to the current ratio, which should alert you that something was not removed.
Check yourself
Current assets: stock 12 000, debtors 8 000, cash 2 000. Current liabilities: creditors 10 000 and a bank overdraft 5 000. Find both ratios.
Answer
Current assets = 12 000 + 8 000 + 2 000 = 22 000. Current liabilities = 10 000 + 5 000 = 15 000.
Current ratio = 22 000 ÷ 15 000 = 1.47 : 1.
Quick ratio = (22 000 − 12 000) ÷ 15 000 = 10 000 ÷ 15 000 = 0.67 : 1. The business has less than 1 of quick assets for every 1 owed, so it relies on selling stock.
What to study next
Move on to interpreting efficiency ratios, which explains how fast stock, debtors and creditors move. Record any misclassified items in the mistake log.
If you want a teacher to watch you sort a statement, see online one-to-one Accounting tuition.