Reviewing the health of your business: liquidity ratios
This blog post was first published on 6 October 2014 and was last updated on 4 January 2018.
This month at FreeAgent we’re looking at some useful tools that can help you review the health of your business. We’ve asked our chief accountant, Emily, to begin by explaining one of the main tools that accountants often use to check the financial position of a business: liquidity ratios.
What are liquidity ratios?
A business is “liquid” if it has plenty of cash available to pay its debts at the point that they arise.
There are two liquidity ratios that you can use to check your business; the current ratio and the quick ratio. These are used to check the figures on your balance sheet (which FreeAgent generates for you) to show you how your business is performing. Here’s how each ratio works:
Essentially the current ratio is a way of measuring whether the business has enough cash on hand, or due in shortly, to pay the debts which you either have to pay straight away or in the near future. The ratio itself is a business’s current assets divided by its current liabilities.
Current assets are what your business owns that can be easily converted into cash, for example, money you are owed by your customers (“trade debtors” or “accounts receivable” in accounting-speak), any stock that the business holds for sale, or actual money in the bank account. Current liabilities are sums owed by the business which have to be paid out in less than a year, such as money you owe to your suppliers (“trade creditors” or “accounts payable”), and any money you owe to the taxman or to your staff.
A good ratio for a business to have would be 1 or higher, as it means that the business’s current assets are equal to or more than its current liabilities, and therefore it has at least enough cash to cover its immediate debts.
However, a current ratio of lower than 1 may be bad news - and if your business’s current ratio is less than 1, it’s worth looking at what its debts are. For example, if the business owes you a lot of out-of-pocket expenses but the other debts are minimal, that’s not so bad because you’re hardly going to sue your own business. But if you owe a lot of money to suppliers and to HMRC, and your current ratio is less than 1, it may be time to contact your creditors (that’s people you owe money to), and arrange payment plans.
The quick ratio is the same calculation, but any stock the business holds for sale is omitted from the calculation. That’s to make it easier to tell whether there’s enough cash already in the business, and due in from customers, to pay the business’s debts if, for whatever reason, the stock can’t be sold - perhaps because it’s been damaged, has perished or become obsolete.
A quick ratio of 1 or higher is healthy, because the business would still be able to pay its debts even if none of its stock could be sold. A quick ratio of under 1 may be cause for concern because if your business’s stock was destroyed in an accident like a flood, for example, you might not have enough cash to pay creditors, and it might be time to make sure your stock is adequately insured.
Let’s look at some numbers to help explain this.
Here is an extract from a sample balance sheet, generated by FreeAgent.
The current ratio = current assets / current liabilities = £118,915 / £84,562 = 1.41.
That’s greater than 1 which is good news. The business has enough cash to cover its immediate debts.
The quick ratio = (current assets less stock) / current liabilities = (£118,915 - 84) / £84,562 = 1.41.
Again this is very good news because even if none of the stock could be sold, the business would still have plenty of money to pay its debts.
Remember when you’re running a business you should always try to ensure it has good liquidity so you don’t face any unwelcome problems in the future. Knowing your liquidity ratios now - and checking them regularly - could save you a great deal of hassle down the line.
In the second part of this series on some of the tools that can help you review the health of your business, Emily explains the break-even point.
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