Revision and practice on the key liquidity ratios, how to calculate and interpret them, and how businesses manage liquidity.
Key vocabulary: Current Ratio, Acid Test Ratio, Receivable Days, Payable Days
Key Concepts
Understanding Liquidity
Liquidity measures how easily a business can access cash to pay bills due in the short term. Liquidity ratios assess whether current assets are sufficient to cover current liabilities.
A business can be profitable but illiquid — it has profit on paper but insufficient cash to pay immediate bills. Illiquidity can force a business to close, even if it's fundamentally sound. Current assets include cash, receivables (amounts owed by customers) and inventory; current liabilities include payables (amounts owed to suppliers) and overdrafts.
The Four Key Liquidity Ratios
Liquidity ratios measure a business's ability to meet its short-term debts, and are closely watched by lenders and investors.
Current ratio = Current assets ÷ Current liabilities. A ratio of around 1.5-2.0 is generally considered healthy; below 1.0 suggests the business may struggle to pay its short-term debts.
Acid test ratio = (Current assets − Inventory) ÷ Current liabilities. A stricter test than the current ratio, since it excludes stock, which may not be easily or quickly converted to cash.
Payable days = (Payables ÷ Cost of sales) × 365. Shows the average number of days the business takes to pay its suppliers — a higher figure keeps cash in the business for longer.
Receivable days = (Receivables ÷ Revenue) × 365. Shows the average number of days it takes customers to pay — a lower figure means faster cash collection.
Interpreting Liquidity Ratios
Liquidity ratios are simple to calculate but need careful interpretation — the "right" level depends on the industry and business model.
A current ratio of 1.0-2.0 is typically considered healthy, though this varies by industry — supermarkets, for example, often operate with ratios below 1.0 because they collect cash from customers immediately.
An acid test ratio above 1.0 is generally desirable; below 0.8 suggests potential liquidity stress, meaning the business may struggle to meet urgent obligations without selling stock.
Very high liquidity ratios (above around 3.0) can suggest a business is holding excess, inefficiently-used cash that could instead be invested in growth or returned to shareholders.
The trend matters as much as the single figure — liquidity ratios declining month to month can signal a developing cash flow problem, even if the current figure still looks acceptable.
Managing Liquidity
Businesses manage liquidity by optimising working capital — accelerating cash inflows, delaying outflows, and maintaining adequate cash reserves.
Chase receivables: collect cash from customers quickly through effective credit management and early payment incentives.
Optimise inventory: hold appropriate stock levels to balance customer service against tying up cash in inventory.
Manage payables: negotiate reasonable payment terms with suppliers, while still maintaining good relationships by paying on time.
Maintain cash reserves: some businesses keep an operating cash balance (e.g. 2-4 weeks of operating expenses) to handle unexpected shortfalls or opportunities.
Arrange overdraft facilities: to cover timing mismatches between receipts and payments.
Real-World Case Studies
UK supermarkets — a healthy business with a current ratio below 1.0
UK supermarkets like Tesco commonly operate with negative working capital and a current ratio below 1.0 — which, taken in isolation, might look like a liquidity warning sign. In practice, it's a deliberate and efficient business model: supermarkets sell most goods for cash or card straight away, while buying stock from suppliers on credit, meaning cash from sales arrives well before payment is due to suppliers. This is exactly why this lesson's concepts stress that liquidity ratios must be interpreted in the context of the industry, not read as a single "safe" number that applies to every business.
Source: verified via search, September 2026 — analysis of UK supermarket working capital cycles and credit policy.
Travis Perkins — managing payable days by doubling supplier payment terms
Research from Good Business Pays found that Travis Perkins Trading Company recently doubled its standard payment terms, meaning some suppliers invoicing early in the month can wait nearly three months to be paid — with 58% of its invoices, worth over £791 million, reported as paid late over a six-month period in late 2025. This is payable days management in action: extending how long a business takes to pay suppliers keeps cash inside the business for longer, directly improving its own liquidity position — but, as this lesson's concepts also note, at a real cost to supplier relationships, which is why UK government proposals are moving to cap payment terms at 60 (and eventually 45) days.
Source: verified via search, September 2026 — Good Business Pays research reported via LBC, and Forbes' coverage of UK late payment reform.
Quick Quiz
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1. Current assets are £900,000 and current liabilities are £600,000. What is the current ratio?
2. Why does the acid test ratio exclude inventory?
3. A business has a current ratio of 0.8:1. Is this automatically a sign of financial trouble?
4. Which figure would rise if a business successfully negotiated longer payment terms with its suppliers?
5. A business has a current ratio of 4.5:1. What might this suggest?
Score: 0 / 0
Quick Knowledge Check
Short, snappy recall questions — tap to reveal the answer.
What is the current ratio formula? (1 mark)
Current assets ÷ Current liabilities.
What is the acid test ratio formula? (1 mark)
(Current assets − Inventory) ÷ Current liabilities.
What is generally considered a healthy current ratio range? (1 mark)
Around 1.5 to 2.0.
Key Term Flashcards
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Current ratio
Current assets ÷ Current liabilities. Around 1.5-2.0 is generally considered healthy.
Acid test ratio
(Current assets − Inventory) ÷ Current liabilities. A stricter liquidity test that excludes stock.
Payable days
(Payables ÷ Cost of sales) × 365. The average number of days a business takes to pay its suppliers.
Receivable days
(Receivables ÷ Revenue) × 365. The average number of days customers take to pay.
A*/A Stretch
Examiner's eye
Always compare a liquidity ratio to something — a healthy benchmark, the industry norm, or the business's own figure from a previous year — rather than just stating the number. A ratio in isolation, without a point of comparison, rarely earns analysis marks.
Synoptic link
Connecting to gearing (L1, this unit): A business with high gearing often needs to watch its liquidity ratios especially closely, since it already has significant fixed debt repayment obligations — a liquidity squeeze is far more dangerous for a highly-geared business than for one funded mainly through share capital or retained profit.
Try This With AI
Before using this: AI tools can get facts or mark scheme details wrong, and quality varies by tool. Always check anything factual against your notes or ask your teacher.
Give me current assets, inventory and current liabilities figures for a fictional business. Ask me to calculate its current ratio and acid test ratio, and to interpret whether its liquidity position looks healthy. Then mark my calculations and tell me whether my interpretation properly considered what "healthy" means for that type of business.