The ability of a business to meet current financial obligations such as loan repayments, expenses and creditors is crucial to its continued existence. A business is said to be ‘liquid’ when it is able to pay its debts on time. It is equally important that the business collect from debtors their outstanding amounts on time. Two ratios directly related to the liquidity or solvency of businesses, are the Current Ratio and the Acid Test Ratio.
This ratio provides indication of the business to meet its short term financial commitments. The comparison is made with (current) assets which will become liquid within a year and (current) liabilities which should be paid within the same period of one year. This will indicate if the business has enough short term assets to meet its short term payments. The formula for current ratio is:
Acid Test Ratio
Acid test ratio indicates the ability of the business to meet it short term payments given the situation where all debtors settle and all creditors are paid at the same time. The formula for Acid Test ratio is: