Liquidity: profit versus cash and the liquidity ratios

Profit is not cash

Profit is revenue minus costs over a period. Cash is the money actually held. They differ because:

• Sales on credit count as revenue now, but the cash arrives later.
• Inventory is paid for before it is sold.
• Buying equipment uses cash, but only depreciation counts as a cost each year.
• Loans and capital bring in cash but are not revenue; loan repayments use cash but are not costs.

So a growing, profitable firm can be short of cash, and a loss-making firm can have cash for a while.

The statement of financial position

Liquidity ratios use two figures from the statement of financial position (balance sheet):

• Current assets: cash, trade receivables (customers who owe money) and inventory, which will turn into cash within a year.
• Current liabilities: debts due within a year: trade payables (suppliers owed), overdrafts, short-term loans, tax due.

Current ratio and acid test ratio

• Current ratio = current assets / current liabilities. Often given as x:1. A ratio around 1.5 to 2 is often quoted as comfortable; below 1 means current liabilities exceed current assets.
• Acid test ratio (liquid capital ratio) = (current assets - inventory) / current liabilities. It removes inventory, the least liquid current asset, since it may be hard to sell quickly. Around 1 is often quoted as comfortable.

These are rules of thumb: supermarkets sell inventory for cash daily and run safely with low ratios. A very high ratio can mean idle cash or too much inventory, which earns nothing.

Current assets $84,000, of which inventory $36,000; current liabilities $60,000

Worked example

Using the figures in step 3, comment on the firm's liquidity.

1. Current ratio 1.40:1: current assets cover current liabilities, but below the 1.5 often quoted as comfortable.
2. Acid test 0.80:1: without selling inventory the firm could pay only 80% of its short-term debts.
3. It depends heavily on selling inventory; if sales slow, it may struggle to pay suppliers.

Answer: Liquidity is weak, especially on the acid test, so the firm relies on turning inventory into cash.

Check yourself

1. Current assets are $150,000 and current liabilities are $100,000. Calculate the current ratio.
   Show answer

   1.50. 150,000 / 100,000 = 1.5, so 1.5:1.

2. Current assets are $150,000, including inventory of $70,000. Current liabilities are $100,000. Calculate the acid test ratio.
   Show answer

   0.80. (150,000 - 70,000) / 100,000 = 0.80, so 0.8:1.

3. Cash $12,000, trade receivables $28,000, inventory $45,000; trade payables $38,000, overdraft $12,000. Calculate the current ratio to 2 decimal places.
   Show answer

   1.70. Current assets 85,000 / current liabilities 50,000 = 1.70.

4. Using the same figures (cash $12,000, receivables $28,000, inventory $45,000; payables $38,000, overdraft $12,000), calculate the acid test ratio to 2 decimal places.
   Show answer

   0.80. (85,000 - 45,000) / 50,000 = 0.80.

5. Why does the acid test ratio exclude inventory?
   • Inventory is a liability
   • Inventory has no value
   • Inventory is included in current liabilities
   • Inventory may not be quickly turned into cash
   Show answer

   Inventory may not be quickly turned into cash. It may take time to sell, or sell only at a discount.

6. Which explains how a profitable business can run short of cash?
   • Its revenue is greater than its costs
   • It sells mostly on credit and customers pay slowly
   • It has a high gross profit margin
   • It pays its suppliers late
   Show answer

   It sells mostly on credit and customers pay slowly. Revenue is recorded before the cash arrives.

7. A current ratio of 4:1 might suggest that the business
   • is about to become insolvent
   • has too many current liabilities
   • is making a loss
   • has too much money tied up in idle cash or inventory
   Show answer

   has too much money tied up in idle cash or inventory. Very high liquidity means resources that could be earning a return are sitting idle.

8. Define liquidity.
   Show answer

   Liquidity is the ability of a business to pay its short-term debts (current liabilities) as they fall due, using cash or assets that can quickly be turned into cash.. Ability to pay short-term debts as they fall due.

Practise with instant feedback Print this lesson

Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Business specification (2018)

Last updated 8 November 2026. Spotted a mistake? Tell us.