The current ratio is a short-term liquidity ratio used to calculate the ability of an organization to meet its short-term debts (within the next twelve months of the balance sheet date). It calculates the value of an organization’s liquid assets relative to its short-term liabilities.

Recall from the balance sheet (Unit 3.4) that a firm's liquid assets are comprised of:

• cash

• stock (also known as inventory), and

• debtors

Also, recall that a firm's current liabilities (short-term debts) are comprised of:

• bank overdrafts

• trade creditors, and

• short-term loans.

The current ratio is calculated using the formula:

For example, if a firm’s current assets are valued at $25 million and its current liabilities equal $15 million, then the current ratio = $25m million ÷ $15 million = 1.67 (or sometimes expressed as 1.67:1). This figure means that for every $1 of current liabilities that the firm owes to its creditors, it has $1.67 in highly liquid current assets.

In general, the minimum figure for the current ratio for any organization, must be 1.0 (or 1:1). What this means is that the firm has just enough liquid assets to pay off its short-term liabilities.

To improve the current ratio, a business needs to increase its current assets and/or reduce its current liabilities. Hence, it can take any combination of the following actions:

• Attract more customers, perhaps by changing the pricing strategy and/or improving its promotional strategies.

• Encourage customers to pay by cash, thereby improving the firm’s cash inflows.

• Use any available cash to pay off short-term debts, thereby reducing the interest (debt) burden on the business in the long run.

• Negotiate with suppliers for an extended trade credit period (e.g. from 30 days to 40 days), thereby improving its own liquidity position.

The acid test ratio (also known as the quick ratio) is a short-term liquidity ratio used to measure an organization’s ability to pay its short-term debts (within the next twelve months of the balance sheet date), without the need to sell any stock (inventories). Stocks are ignored from the calculation as some inventories are not highly liquid, such as work-in-progress or very expensive finished goods sold in niche markets. This makes the stock difficult to sell or convert into cash in a short period of time.

Calculating the acid test ratio is similar to the current ratio except that stocks (inventories) are excluded from the calculation of current assets. As mentioned above, this is because stocks are not always highly liquid assets for some businesses. It tends to be the preferred measure of short-term liquidity for businesses with inventories that are not always easily converted into cash and/or for businesses that have a long working capital cycle.

The acid test ratio is calculated using the formula:

For example, if a business has current assets equal to $18 million, current liabilities equal $12 million and stock equals $2 million, then the firm’s acid test ratio = ($18 million – $2 million) ÷ $12 million = $16m / $12m = 1.33 (or sometimes expressed as 1.33:1). This figure means the business has $1.33 worth of liquid assets (without having to sell any of its inventory) for every $1 of current liabilities that the organization incurs.

It is usual to expect as a bare minimum that firms have an acid test ratio of no less than 1:1, otherwise it would mean that the business has a serious liquidity problem. For example, an acid test ratio of 0.8:1 would mean the business only has $0.80 of current assets (ignoring its illiquid stocks or inventories) for each $1 of current liabilities that it owes to creditors. Hence, the business has insufficient liquid funds to pay off its short-term debts.

To improve the acid test ratio, a business can opt to:

• Use the same methods that improve the current ratio (essentially, any combination of methods that raise cash inflows for the business and/or reduce its cash outflows).

• Improve its stock control management system (see Unit 5.5) in order to reduce the cash outflows associated with poor stock control management. This is because the value of a firm’s acid test ratio improves as its level of stocks (inventories) falls.

• The acid test ratio (also known as the quick ratio) is a short-term liquidity ratio used to measure an organization’s ability to pay its short-term debts (within the next twelve months of the balance sheet date), without the need to sell any stock (inventories).

• The current ratio is a short-term liquidity ratio used to calculate the ability of an organization to meet its short-term debts (within the next twelve months of the balance sheet date).

• Liquidity refers to the ease with which a business can convert its assets into cash without affecting its market value, i.e., it measures a firm’s ability to repay short-term liabilities without having to use external sources of finance.

• Liquidity ratios are a category of financial ratios used to measure the extent to which an organization can pay off its short-term debts using its current (liquid) assets.

Muller Books Limited (MBL) is a small business specializing in publishing and distributing educational books and resources. The privately listed company was founded by Sarah Muller. MBL has a small office in Dresden, Germany. The company employs 4 full-time staff and several part-time staff. Sarah has a good working relationship with her staff and the local bank manager.

MBL has enjoyed several years of expansion in the provision of online education products, such as interactive e-books and online teacher training courses for a wide range of subjects. However, these are becoming somewhat dated and several rival companies have recently established an online presence in the market. The booming economy has also meant that interest rates in Germany are on an upwards trend.

Five years ago, Sarah was able to secure a patent (legal protection) on a piece of software used for MBL’s online teacher training. The company has been dependent on this software for establishing a broad customer base. Sarah has been informed by Lucy Croft-Wang, her accountant, that MBL’s software developmental expenses have risen dramatically. Lucy presented the following financial information for MBL as at 31st December 2021, which raised some working capital and liquidity issues. All figures are expressed in euros (€):

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