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Can the business pay its short-term debts as they fall due?

Calculate and interpret the current ratio and the quick (acid-test) ratio

A simple answer to the N(A)-Level Principles of Accounts outcome on liquidity ratios. The current ratio and the quick ratio, how to calculate each, what a healthy figure looks like, and what they reveal about paying debts.

Generated by Claude Opus 4.89 min answer

Reviewed by: AI editorial process; not yet individually human-reviewed

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  1. What this dot point is asking
  2. The answer
  3. Examples in context
  4. Try this

What this dot point is asking

SEAB wants you to calculate and interpret the current ratio and the quick (acid-test) ratio. Liquidity is about survival: a profitable business can still fail if it cannot pay its bills on time. The central insight is that liquidity ratios compare what a business can quickly turn into cash with what it owes soon, and the quick ratio is the stricter test because it leaves out inventory.

The answer

The two ratios

Ratio Formula Measures
Current ratio current assetscurrent liabilities\dfrac{\text{current assets}}{\text{current liabilities}} Whether short-term assets cover short-term debts
Quick (acid-test) ratio current assets−inventorycurrent liabilities\dfrac{\text{current assets} - \text{inventory}}{\text{current liabilities}} The same, but excluding slow-to-sell inventory

Both are usually written as a ratio to 1, such as 2 ⁣: ⁣12\!:\!1.

The current ratio

The current ratio shows how many dollars of current assets the business has for each dollar of current liabilities. A figure around 2 ⁣: ⁣12\!:\!1 is often seen as comfortable, though it varies by business. Too low and the business may struggle to pay bills; very high may mean cash is sitting idle.

The quick ratio

The quick ratio is stricter because it removes inventory, the current asset that takes longest to become cash (it must be sold, and credit sales must then be collected). A quick ratio around 1 ⁣: ⁣11\!:\!1 suggests the business can meet its debts without relying on selling inventory.

Why liquidity matters

A business with strong profits but weak liquidity can run out of cash to pay suppliers, wages or loans, and may be forced to stop trading. Liquidity ratios warn of this before it happens.

Examples in context

Example 1. Cash tied up in stock. A shop has a healthy current ratio of 2.5 ⁣: ⁣12.5\!:\!1, but most of its current assets are slow-moving inventory. Its quick ratio is only 0.8 ⁣: ⁣10.8\!:\!1, revealing that if suppliers demanded payment now, it could not pay without selling stock. The two ratios together expose a risk the current ratio alone would hide.

Example 2. Improving liquidity. A business with a current ratio of 1 ⁣: ⁣11\!:\!1 is worried it cannot pay upcoming bills. It arranges a long-term loan, which raises bank (a current asset) without raising current liabilities, lifting both ratios. This shows how a business can act on a weak liquidity ratio rather than simply reporting it.

Try this

Q1. Current assets are \24,000andcurrentliabilitiesare and current liabilities are \12,00012,000. State the current ratio. [2 marks]

  • Cue. 24 00012 000=2 ⁣: ⁣1\dfrac{24\,000}{12\,000} = 2\!:\!1.

Q2. Current assets are \20,000,ofwhichinventoryis, of which inventory is \8,0008,000; current liabilities are \10,000$. Find the quick ratio. [2 marks]

  • Cue. 20 000−8 00010 000=12 00010 000=1.2 ⁣: ⁣1\dfrac{20\,000 - 8\,000}{10\,000} = \dfrac{12\,000}{10\,000} = 1.2\!:\!1.

Q3. Explain why a business with good profits might still have poor liquidity. [2 marks]

  • Cue. Profit can be tied up in inventory, receivables or non-current assets rather than cash, so the business may lack the ready funds to pay its short-term debts.

Exam-style practice questions

Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

Original6 marksA business has current assets of \18\,000(includinginventoryof (including inventory of \6 0006\,000) and current liabilities of \9\,000$. (a) Calculate the current ratio and the quick ratio. (b) Comment on the business's ability to pay its short-term debts.
Show worked answer →

(a) Current ratio =current assetscurrent liabilities=18 0009 000=2 ⁣: ⁣1= \dfrac{\text{current assets}}{\text{current liabilities}} = \dfrac{18\,000}{9\,000} = 2\!:\!1.

Quick ratio =current assets−inventorycurrent liabilities=18 000−6 0009 000=12 0009 000=1.33 ⁣: ⁣1= \dfrac{\text{current assets} - \text{inventory}}{\text{current liabilities}} = \dfrac{18\,000 - 6\,000}{9\,000} = \dfrac{12\,000}{9\,000} = 1.33\!:\!1.

(b) A current ratio of 2 ⁣: ⁣12\!:\!1 means the business has \2ofcurrentassetsforevery of current assets for every \11 of current liabilities, which is comfortable. The quick ratio of 1.33 ⁣: ⁣11.33\!:\!1, which excludes inventory, is still above 1 ⁣: ⁣11\!:\!1, so the business can pay its short-term debts even without selling inventory.

What markers reward: both ratios with formulae, expressed as a ratio to 1, and a comment that the business can meet its short-term debts.

Original5 marksExplain why the quick ratio excludes inventory, and state one action a business could take if its current ratio was too low.
Show worked answer →

The quick ratio excludes inventory because inventory is the least liquid current asset: it must first be sold (and then, if sold on credit, collected) before it becomes cash. Excluding it gives a stricter test of whether the business can pay its debts immediately.

One action to improve a low current ratio: the business could obtain a long-term loan (increasing cash, a current asset, without increasing current liabilities), or sell surplus non-current assets for cash, or reduce drawings to keep more cash in the business.

What markers reward: explaining that inventory is the least liquid asset and may not quickly become cash, and one sensible action such as raising long-term finance or reducing drawings.

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