Liquidity ratios

Liquidity ratios illustrate the solvency of a business. In order to determine whether or not it is in a position to repay its day-to-day debts, the short-term assets and liabilities need to be focused on. The point of these ratios is to show whether the business always has enough current assets to cover any immediate bills that arise (current liabilities).

Current ratio

$Current ratio = \frac{Current assets}{Current liabilities}$

If the current ratio is equal to 1, it means that the business has the exact amount of current assets to cover the current liabilities. However, this is not a favourable state because if a sudden increase in current liabilities occurs, the business will not be able to afford it and might run into bankruptcy. Having too high of a ratio is also not good. For example, if the current ratio is 2, that means that the business has twice as many current assets to cover current liabilities, which means that the business is not using the resources efficiently. Managers should aim at a current ratio of 1.5.

Acid test ratio

This is a more severe test of liquidity as it excludes stock from current assets.

$Acid test ratio = \frac{Current assets-stock}{Current liabilities}$

If the ratio is less than 1, this means that the business’ current assets less stock cannot cover the current liabilities of the business. Checking this ratio is important because stock are not guaranteed to be sold and they may become obsolete or deteriorate, which means that business will no longer be able to rely on stocks to improve their working capital. Therefore, firms should aim to have an acid test ratio at around 1.

Improving Liquidity Ratios

Improving a company’s liquidity ratios involves enhancing the company’s cash position and overall short-term financial stability. Strategies include:

Managing Receivables: Implementing more efficient billing and collections processes can shorten the receivables turnover period, improving cash flow.
Optimizing Inventory Levels: Adopting inventory management techniques such as Just-In-Time (JIT) can reduce inventory levels, freeing up cash and improving the acid test ratio.
Extending Payables: Negotiating longer payment terms with suppliers can improve liquidity by extending the time available to pay off current liabilities.
Refinancing Short-term Debt: Converting short-term debt into long-term debt can decrease current liabilities, improving current and acid test ratios.
Increasing Sales Revenue: Boosting sales through marketing strategies or diversifying product lines can increase cash flow and current assets.

Industry Example: Retail Company

Consider “RetailCo,” a retail company experiencing liquidity challenges reflected in low current and acid test ratios. RetailCo’s management undertakes a comprehensive review of its financial strategies to improve its liquidity position.

Initial Challenge:

RetailCo’s current ratio stood at 0.8, and its acid test ratio was 0.5, signaling potential liquidity issues.

Strategic Actions Taken:

Efficient Receivables Management: RetailCo implemented an online invoicing system with automatic reminders to reduce the average collection period from 45 to 30 days.
Inventory Optimization: RetailCo adopted a JIT inventory system, significantly reducing its inventory holding costs and excess stock, thereby improving its acid test ratio.
Supplier Negotiations: RetailCo negotiated extended payment terms with its suppliers from 30 to 60 days, enhancing its short-term liquidity.
Debt Refinancing: RetailCo refinanced some of its short-term debt into long-term debt, reducing its current liabilities.
Sales Promotions: RetailCo launched targeted sales promotions to clear older stock and introduce new product lines, boosting sales and cash inflows.

Outcomes:

These strategies improved RetailCo’s current ratio to 1.2 and its acid test ratio to 0.9 within a year, enhancing its liquidity and financial stability.

Conclusion

Liquidity ratios, particularly the current ratio and acid test ratio, are essential indicators of a company’s short-term financial health and its ability to meet its obligations. Improving these ratios requires strategic actions focused on managing receivables, optimizing inventory, extending payables, refinancing debt, and increasing sales revenue. The example of RetailCo illustrates how a comprehensive approach to managing liquidity can significantly improve a company’s financial position. Understanding and applying these concepts is crucial for students of IB Business & Management, equipping them with the knowledge to make informed financial decisions in their future careers.