Calculate and interpret liquidity ratios
Use the current and acid test ratios to discuss short-term obligations without treating a single ratio as a universal target.
Exam scope and assessment notes
Cambridge International AS & A Level Accounting 9706, 2026–2028 syllabus, Version 2. These original lessons cover objectives 1.6.1–1.6.2: stakeholder information needs, communication, the listed profitability, liquidity and efficiency ratios, interpretation, improvement measures and limitations. Ratio formulae follow the official syllabus appendix; use its formulae in candidate responses. Practice is self-checked, not an official Cambridge grade; timed Papers 1–4 and human subject-teacher review remain outstanding.
Before you begin
- Use the Topic 1.5 statements and distinguish revenue, gross profit, operating profit, profit for the year, assets, liabilities and equity before selecting a ratio.
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
Current assets are $90,000 and current liabilities are $60,000. What is the current ratio?
What you will learn
- Calculate current ratio and acid test ratio
- Interpret liquidity using asset quality and payment timing
- Evaluate possible liquidity measures and their trade-offs
Calculate both ratios from the same reporting date
Current ratio = current assets ÷ current liabilities. Acid test ratio = (current assets − inventory) ÷ current liabilities. Present each as a ratio, such as 1.5:1, rather than multiplying by 100. Use the balances requested, usually year-end unless the question specifies another basis.
The current ratio includes inventory; the acid test removes it because inventory may take time to sell and convert into cash. Neither ratio directly shows when each receivable will be collected or each liability will fall due.
Read liquidity with composition and timing
A higher current ratio may indicate more short-term resources relative to current obligations, but could also reflect slow-moving inventory or overdue receivables. A low acid test ratio is more concerning when the business cannot turn inventory into cash quickly; it may be less concerning where stock sells rapidly and cash receipts are reliable.
Possible measures include improving credit control, reducing excess inventory, negotiating supplier terms, arranging suitable longer-term finance or preparing a cash budget. Each has a cost or risk: discounts can reduce profit, tighter credit can lose customers, and delaying suppliers may damage relationships.
Pause and explain
Current assets are $72,000, including inventory of $24,000; current liabilities are $48,000. What is the acid test ratio?
Worked example
At year end a retailer has inventory $25,000, trade receivables $20,000, bank $15,000 and current liabilities $40,000. Calculate the current and acid test ratios and identify one question the ratios cannot answer.
Show the worked solution
- Current assets = 25,000 + 20,000 + 15,000 = $60,000.
- Current ratio = 60,000 ÷ 40,000 = 1.5:1.
- Acid test ratio = (60,000 − 25,000) ÷ 40,000 = 0.875:1, or about 0.88:1.
- Check when the receivables are expected and liabilities are due; year-end ratios do not show that timing.
Answer Current ratio 1.5:1; acid test ratio 0.875:1 (about 0.88:1). The ratios alone do not show the collection and payment dates or the saleability of inventory.
Try a topic test
Choose Easy, Normal or Difficult. Save your answers and open worked review after finishing.
Test this topic →From guided practice to a new situation
Write your answer and reasoning first. Use a hint only if you are stuck. The model solution is for self-checking; your written work is not automatically marked.
A company has cash $8,000, receivables $22,000, inventory $30,000 and current liabilities $40,000. Calculate both ratios and state which is more cautious about inventory.
Give me a hint
The acid test excludes the inventory balance.
Compare my reasoning
- Current assets = $60,000; current ratio = 60,000 ÷ 40,000 = 1.5:1.
- Quick assets = 8,000 + 22,000 = $30,000.
- Acid test ratio = 30,000 ÷ 40,000 = 0.75:1; it excludes inventory.
Current ratio 1.5:1; acid test 0.75:1. The acid test is more cautious because it excludes inventory.
Look for these in your work
- Current assets total correct
- Current ratio correct
- Acid test formula and interpretation correct
A business’s current ratio rises from 1.2:1 to 1.8:1, but its inventory days also rise from 40 to 85 days. Explain why the current-ratio movement alone is insufficient evidence of improved liquidity.
Give me a hint
Check whether the increase in current assets comes from cash, collectible receivables or stock that is taking longer to sell.
Compare my reasoning
- The current ratio includes inventory at its recorded value.
- Longer inventory days may mean more cash is tied up before stock is sold.
- Review the acid test, inventory condition, debtor collection and liability due dates before judging liquidity.
The increase may be driven by slower-moving inventory rather than cash or collectible receivables. Compare the acid test and the quality and timing of current assets and liabilities before concluding that liquidity improved.
Look for these in your work
- Inventory inclusion identified
- Cash tied up explained
- Additional evidence named
A manager proposes granting all customers longer credit terms to raise sales, although cash is tight. Evaluate the proposal and recommend evidence to review first.
Give me a hint
Consider both the possible revenue benefit and the extra time before cash collection.
Compare my reasoning
- Longer credit could attract sales but may lengthen receivable days and increase bad-debt exposure.
- Check customer demand, contribution from extra sales, existing collection patterns and available cash forecasts.
- A targeted offer or credit limit may balance sales opportunities with collection risk; compare results rather than extending terms to everyone automatically.
Longer terms may support sales but delay cash and increase collection risk. Review contribution, debtor history and cash forecasts; test a targeted policy with credit limits and monitor receivable days and bad debts.
Look for these in your work
- Sales benefit qualified
- Liquidity risk named
- Evidence-led limited action proposed
Common mistakes
- Multiplying liquidity ratios by 100 instead of presenting them as ratios
- Subtracting trade receivables instead of inventory in the acid test formula
- Assuming a higher current ratio always means stronger cash management
What can you explain now?
Which item is deducted from current assets in the acid test ratio?
Compare with the explanation
Inventory
The formula excludes inventory but retains other current assets.
After trying it yourself, choose your next review. This is your self-assessment.
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Make it stick
Write the current and acid test formulas and give one limitation shared by both ratios.
If you needed the solution, close it and solve the problem again from a blank page. A correct answer is stronger when you can explain the reason for each step.