Liquidity Ratios Video Lecture | Accountancy Class 12 - Commerce

hi everyone welcome to this business
topic video which is going to provide an
overview an introduction to the
important topic of liquidity ratios
let's just first of all explain what a
liquidity ratio is compared with all the
other financial and other ratios that
you may have come across such as
profitability or efficiency ratios
liquidity is really all about the
ability of the business develop a amount
that it owes when there's you so does it
have the cash or other assets that
enables it to pay its current
liabilities liquidity is all about cash
flow as a result the kind of information
you need to calculate the quiddity she
owes is largely going to be found not
from the income statement which is
looking at the income and expenditure of
the business over time or the cash flow
statement which looks at the historical
movements in cash the information you
need for liquidity ratios is going to be
drawn for what's known as the statement
of financial position or mods it's more
commonly known the balance sheet the
balance sheet is this snapshot of what
the business owns or is owed which is
the assets and what it owes to others
which are the liabilities so the concept
of liquidity essentially requires you to
consider and compare two different types
of information from the balance sheet
the current assets of the business and
compare them with the current
liabilities of the business let's just
quickly look at what we mean by current
assets and current liabilities perhaps
one of the most common current assets of
a business is the cash the cash in hand
or the cash in at the bank that the
business has most businesses operate
with at least some cash in the bank but
of course there are two other main types
of current asset there is the stock or
the inventories that are held by the
business perhaps at the warehouse
perhaps as work-in-progress or raw
materials that are flowing through the
production process for a manufacturing
business so a lot of businesses
particularly manufacturing businesses
hold significant
stocks as of course to retailers and
wholesalers and thirdly and this happens
in just about all businesses of any
major size you've got amounts that are
owed to the business by customers known
as trade debtors these are customers
who've been allowed to have sales
allowed to have the product in return
for agreeing to pay their invoices a
little bit later trade debtors so those
are the three main categories of current
assets and what we need is those current
assets to be enough to be able to pay
what the business owes which are known
as current liabilities two main ones to
look out for firstly of course and this
again is its common in most businesses
amounts that are owed to suppliers so in
this case we typically call these trade
creditors where the supplier has
provided us with some goods and services
we owe them the money and we should be
paying that that invoice from the
supplier at the right time at some stage
in the future
the second current liability to look out
for and this can happen at the same time
as a business having cash in hand or at
the bank is an overdraft facility or an
overdraft amount owed to the bank which
in theory is repayable on demand and
therefore needs to be included in
current liabilities so we can see we
compare current assets with current
liabilities and the concept of liquidity
is to see what the relationship is
between the two of them
let's look therefore at a really simple
example just to show you how the main
liquidity ratio she's known as the
current ratio how that is calculated so
in this case with a very simple business
and this is a snapshot of some of the
information from the balance sheet the
balance sheet data had cash in hand of
10,000 pounds it was holding stocks or
inventories at a cost of 30,000 pounds
that's tied up in in stocks and it was
also owed 60,000 pounds by its customers
trade debtors of 60,000 pounds on the
other side of the equation amounts that
the business needs to pay out at some
stage in future it owned its creditors
likely to be suppliers 45,000 pounds and
it also had a 5
5,000 pound bank overdraft money it had
effectively loaned from the bank
that's our simple example let's now have
a look at how we calculate the most
popular the most common liquidity ratio
it's known as the current ratio and it's
really easy all you do is you divide
current assets by current liabilities so
add them all up together to start with
so our cash of 10 our stocks of 30 are
trade debtors of 60 gives us total
current assets of 100,000 pounds we add
together the current liabilities of the
the trade creditors of 45 plus the bank
overdraft of 5 that gives us total
current liabilities of 50,000 pounds and
the way you calculate the current ratio
is really easy you divide one by the
other current assets over current
liabilities 100/50 should even with my
maths
give you the answer to so the current
ratio is two in other words current
assets are twice the level of current
liabilities well that's your ratio
calculator but I guess the most
important thing is what does it mean now
the textbooks will all describe this in
different ways but essentially most
businesses would want to have a positive
current ratio of more more than one in
other words they've got current assets
that are at least enough to be able to
pay the amounts that it owes and
typically a ratio of between one and a
half two and a half maybe one and a half
to three would suggest that actually the
businesses is in decent position in
terms of liquidity it's got enough
current assets to to pay the bills as
they fold you by contrast at a low
current ratio of below one might suggest
that the business is struggling to pay
its pay its current liabilities of
course it's possible to have a very high
current ratio and that also to be a
problem so coat ratio say five six maybe
ten would suggest that there's far too
much capital invested in the business
perhaps tied up in in excess stocks or
we've allowed our trade debtors our
customers to take too much credit the
key thing about top grade evaluation of
using the current ratio is
just think about what the number means
in context so for example it depending
on which business or industry you're
looking at the current ratio will vary
take a look at major manufacturers or
businesses that are involved in
long-term contracts they often have a
substantial amount tied up in working
progress and inventories in some
industries it's very common for
customers to be given long periods to
pay their debts and therefore trade
debtors tend to be very high so the key
issue is what type of business are you
looking at and what are the typical
levels of the current ratio and also how
does that ratio compare with competitors
because that will give you an indication
as to whether a business's is
competitive in terms of its liquidity
position the other key thing to remember
is to look out for the trend so don't
just calculate the ratio the current
ratio at one point calculated over a
series of periods and see whether it's
going up or down because a sudden
deterioration in the ratio could be a
good indication that the business has
got some cashflow problems that's the
current ratio and I think for most
examples that is currently the the most
certain the most popular and in some
cases the only liquidity ratio you
require to know so check your exam board
but you may also come across this one
which I'll just mention briefly for a
minute or so and it's known as the acid
test ratio and don't worry about the
name it's really a very simple ratio
it's the current ratio but you make one
small adjustment what is different about
the acid test ratio compared to the
current ratio is that you eliminate the
current asset that is typically hardest
to turn into cash and that's inventories
so you imagine cash is easy that's cash
and trade s's you just get them to pay
but with stocks and inventories you
actually have to turn them into a sale
and then perhaps wait for that sale to
be paid for you so inventories can be
typically quite difficult to turn into
cash in the short term so the acid test
is if you like a more stringent test of
liquidity but then you then compare it
with exactly the same current
liabilities that you that you have
calculated with the current ratio so if
we did that with our simple example
remember we had a hundred thousand of
current assets but of that thirty
thousand pounds was tied up in
inventories or stocks if we take those
out of current assets divided by fifty
thousand we see that the acid test ratio
is less than two as you would expect
it's one point four how do you evaluate
this well I guess the same comments as
we made a few minutes ago are also true
that you've got to understand what type
of business you're looking at for some
taking inventories out of current assets
has a very significant impact on the
ratio on the asset test ratio but for
service businesses almost no impact
because very few services service
businesses hold a little stock so you've
got to look out for what type of
industry it is but also not be too
concerned if it's if the ratio is poor
but the business has a high stock
turnover so supermarkets typically
operate on quite a low current ratio and
acid test ratio but it's not a problem
for them because they're constantly
turning that high level stock over
through sales and in particular turning
it into cash so there we go that's a
brief introduction to liquidity ratios
the most important of which is the
current ratio and in other topic videos
we'll take a look at how we can use
liquidity ratio information to help
identify ways of improving the cash flow
of a business