Calculate and interpret liquidity ratios
Calculate the current and acid test ratios and explain why inventory is excluded from the acid test numerator.
Cambridge IGCSE (9–1) Business 0774, 2027–2029 Version 2, Topic 5. Use the supplied data and show calculation steps. Candidates are not assessed on constructing cash-flow forecasts or financial statements. Written practice is self-checked and does not certify exam readiness
Before you begin
- No previous finance study is assumed. Identify the time period, whether a figure is a stock or a flow, and the units before calculating or recommending.
Work on paper. Try each question before revealing help, and explain why your method works.
Quick readiness check
Which item is removed when calculating the acid test ratio?
What you will learn
- Calculate current ratio
- Calculate acid test ratio
- Interpret liquidity cautiously
Current ratio compares current assets and liabilities
Current ratio = current assets ÷ current liabilities, often written as a ratio to 1 or as a number. For example, 1.5:1 means $1.50 of current assets for each $1 of current liabilities at that date.
A larger figure is not automatically better: excess inventory or overdue receivables may be difficult to turn into cash. Compare the business's trading pattern, sector and past results.
Acid test excludes inventory
Acid test ratio = (current assets − inventory) ÷ current liabilities. It focuses on current assets other than inventory, which may take time to sell.
The ratio is a snapshot, not a cash forecast. A seasonal business may have temporary balances; payment dates and receivable quality matter. Do not apply a universal ideal without evidence from the case or comparison.
Pause and explain
How may a current ratio be presented?
Worked example
Current assets are $48,000, including inventory of $18,000. Current liabilities are $24,000. Calculate current and acid test ratios.
Show the worked solution
- Current ratio = 48,000 ÷ 24,000 = 2.0, or 2:1.
- Acid test numerator = 48,000 − 18,000 = 30,000.
- Acid test = 30,000 ÷ 24,000 = 1.25, or 1.25:1.
Answer Current ratio is 2:1 and acid test ratio is 1.25:1. The acid test excludes inventory from current assets.
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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.
Current assets are $72,000, inventory is $27,000 and current liabilities are $36,000. Calculate both liquidity ratios.
Give me a hint
For the acid test, subtract inventory before dividing by current liabilities.
Compare my reasoning
- Current ratio = 72,000 ÷ 36,000 = 2:1.
- Acid test assets = 72,000 − 27,000 = 45,000.
- Acid test = 45,000 ÷ 36,000 = 1.25:1.
Current ratio is 2:1; acid test ratio is 1.25:1. The difference reflects the $27,000 inventory excluded from the acid test numerator.
Look for these in your work
- Current ratio correct
- Inventory removed
- Acid test correct
A firm's current ratio is 1.8:1, but its acid test ratio is 0.6:1. Explain one possible reason for the gap and what to investigate.
Give me a hint
Inventory can make up much of current assets but may not be quickly sold.
Compare my reasoning
- The current ratio includes inventory.
- A much lower acid test suggests a substantial inventory balance relative to liabilities.
- Check stock age, turnover, demand and liability due dates.
Inventory may form a large part of current assets, making the current ratio much higher than the acid test. The business should investigate whether stock is saleable and how quickly it turns over, alongside payment dates and receivable collections.
Look for these in your work
- Formula distinction explained
- Possible cause identified
- Relevant evidence requested
A seasonal retailer's current ratio falls just after its busiest season. Explain why the change needs context before concluding that liquidity has become unsafe.
Give me a hint
Seasonal sales and payments can alter stock, cash and liabilities at a point in time.
Compare my reasoning
- Identify when the statement was prepared relative to the trading season.
- Compare cash receipts, stock and liabilities across comparable periods.
- Check forecast payments rather than using one ratio alone.
The ratio may reflect seasonal inventory purchases, receipts or supplier payments at that date. Compare similar points in earlier seasons and review cash forecasts and liability due dates before deciding whether liquidity is unsafe.
Look for these in your work
- Timing context noted
- Like-period comparison suggested
- Ratio limitation explained
Common mistakes
- Including inventory in the acid test numerator
- Reversing liabilities and assets
- Claiming a universal ideal ratio without context
What can you explain now?
Which item is removed when calculating the acid test ratio?
Compare with the explanation
Inventory
The formula excludes inventory from current assets.
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Make it stick
Why can the acid test ratio give a different picture from the current ratio?
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.