The current ratio, liquidity and gearing

Overview

The current and acid test ratios, healthy liquidity levels, gearing and its formula, worked calculations, high and low gearing, and interest rate risk.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What does a liquidity ratio measure?

   Model answer

   A liquidity ratio measures a business's ability to pay its short-term debts as they fall due. Liquidity compares assets that can quickly become cash with short-term liabilities.

2. 2

   State the formula for the current ratio.

   Model answer

   The current ratio equals current assets divided by current liabilities. The current ratio is written in the form 1.5:1.

3. 3

   A law firm has current assets of £42,000 and current liabilities of £24,000. Calculate its current ratio.

   Model answer

   The current ratio is 1.75:1. The working is 42,000 ÷ 24,000 = 1.75.

4. 4

   What current ratio is often seen as healthy?

   Model answer

   A current ratio of about 1.5:1 to 2:1 is often seen as healthy. The right level varies from one industry to another.

5. 5

   What does a current ratio below 1:1 suggest?

   Model answer

   The business has fewer current assets than current liabilities. The business may struggle to pay its short-term debts on time.

6. 6

   Why can a very high current ratio be a problem?

   Model answer

   Too much money may be tied up in idle cash, inventory or unpaid invoices. Surplus cash could instead be invested to earn a return.

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