CIMA BA3 Syllabus D. ANALYSIS OF FINANCIAL STATEMENTS - Liquidity Ratios - Notes ^{2 / 5}

What does the current ratio/working capital ratio mean?

This is a measure of the liquidity of a business that compares its current assets with those payables due to be paid within 1 year of the statement of financial position date. 

A high ratio means the current assets are easily sufficient to cover current liabilities. However, if the ratio is too high, it is wasteful as current assets can be used to earn income. 

A ratio of below one, means that current liabilities exceed current assets - this could imply danger of insolvency. 

It is normally thought that a ratio of 2:1 is ideal, but this depends on the type of business and its reliance on credit transactions.

What does the quick ratio mean?

This is similar to the current ratio but it takes the conservative view that inventories may take time to convert into cash and therefore the true liquidity position if measured by the relationship of receivables and cash to current liabilities. 

Again, a high ratio is comforting, but too high of a quick ratio can be wasteful. 

Generally, a ratio of 1:1 is considered ideal, but if the ratio is lower than this, more investigation should be done before it is concluded that the company has liquidity problems.