The current ratio is current assets ÷ current liabilities. The liquid ratio (also called the acid test ratio) is (current assets − inventory) ÷ current liabilities. Both appear when an examiner asks whether a business can pay its short-term debts.
Check the exact wording of the formulas in your current Cambridge syllabus. Whichever version you use, use the same one for every year and every business in a question, so the ratios are compatible. This lesson belongs to ratios and interpretation.
What goes in each group?
Current assets are cash and items expected to turn into cash within the year: inventory, trade receivables, bank balance and cash. Current liabilities are amounts due within the year: trade payables, accrued expenses and a bank overdraft.
A loan repayable in several years is a non-current liability. It does not belong in the denominator of either ratio.
Worked example
Warung Teratai Trading, a fictional business, has these figures at 31 December.
| Current assets | RM | Current liabilities | RM |
|---|---|---|---|
| Inventory | 18,000 | Trade payables | 15,000 |
| Trade receivables | 12,000 | Accrued expenses | 3,000 |
| Bank | 6,000 | ||
| Cash | 1,000 | ||
| Total | 37,000 | Total | 18,000 |
Check: 18,000 + 12,000 + 6,000 + 1,000 = 37,000, and 15,000 + 3,000 = 18,000. It also has a bank loan of RM20,000 repayable in four years.
Step 1, current ratio: 37,000 ÷ 18,000 = 2.06, written 2.06 : 1 (to two decimal places).
Step 2, remove inventory: 37,000 − 18,000 = RM19,000. Check: 12,000 + 6,000 + 1,000 = 19,000.
Step 3, liquid ratio: 19,000 ÷ 18,000 = 1.06 : 1.
Step 4, say what it shows: current assets cover current liabilities about twice, but without inventory the cover is only slightly above one times. The business depends on selling its inventory to be comfortable.
The mistake to watch for
Mistaken answer: “Current ratio = 37,000 ÷ (18,000 + 20,000) = 0.97 : 1, so the business cannot pay its debts.”
The student added the four-year loan to current liabilities. The loan is not due within the year.
The correction is to read the due date of each liability. Only amounts due within the year go in the denominator. The right answer is 2.06 : 1, and the weaker liquid ratio of 1.06 : 1 is the real point to comment on.
A second slip is mixing definitions between years, for example including prepayments in one year and leaving them out in the next. Pick one treatment and apply it to both.
Check yourself
1. A business has current assets of RM45,000, of which inventory is RM20,000, and current liabilities of RM30,000. Find both ratios.
Show answer
Current ratio = 45,000 ÷ 30,000 = 1.5 : 1. Liquid ratio = (45,000 − 20,000) ÷ 30,000 = 25,000 ÷ 30,000 = 0.83 : 1.
2. Inventory RM8,000, receivables RM5,000 and cash RM2,000. Payables RM6,000 and a bank overdraft RM4,000. Find both ratios.
Show answer
Current assets = 8,000 + 5,000 + 2,000 = 15,000. Current liabilities = 6,000 + 4,000 = 10,000. Current ratio = 1.5 : 1. Liquid ratio = (15,000 − 8,000) ÷ 10,000 = 7,000 ÷ 10,000 = 0.7 : 1.
3. A shop has a current ratio of 2.0 : 1 but a liquid ratio of 0.4 : 1. What does the gap tell you?
Show answer
Most of its current assets are inventory. It can meet short-term debts only if that inventory sells at a reasonable price and on time. The ratios do not say whether it will.
Where this leads next
Next, learn to interpret a profitability change with supporting evidence. Use the double-entry and ledger trainer to practise sorting items into the right statement groups, and the ratios practice set for mixed questions.
If liquidity questions still feel like a guessing game about which items count, our teachers can go through them with you in online one-to-one Accounting tuition.