Ratio analysis: liquidity, gearing and the limits of ratios

Liquidity ratios

• Current ratio = current assets / current liabilities. Shows whether short-term assets cover short-term debts. Often expressed as x:1.
• Acid test ratio = (current assets - inventory) / current liabilities. A stricter test, because inventory may be hard to sell quickly.

For the company in the financial statements lesson: current ratio = 1,800 / 1,200 = 1.50; acid test = (1,800 - 900) / 1,200 = 0.75.

Too low: risk of being unable to pay bills. Too high: money tied up in idle stock or cash that could be earning a return. What is 'normal' varies by industry: supermarkets, paid in cash by customers, often run low ratios safely.

Gearing

Gearing ratio = non-current liabilities / capital employed x 100. It shows how much of the long-term finance comes from borrowing.

Here: 3,000 / 9,600 x 100 = 31.25%.

• High gearing (often taken as above 50%): heavy interest payments; vulnerable if interest rates rise or profits fall; lenders may refuse more credit. But owners keep control and, when profits are strong, returns to shareholders are boosted.
• Low gearing: safer, but the firm may be missing chances to grow using cheap borrowing.

Real examples from WBS13 papers

• October 2024, Q1(a): an electronics company had current assets of 218 trillion won and current liabilities of 78 trillion won. Current ratio = 218 / 78 = 2.79 (2.79:1 also accepted).
• January 2025, Q1(a): a music streaming company had non-current liabilities of EUR1,752m and capital employed of EUR3,891m. Gearing = 1,752 / 3,891 x 100 = 45.03%. An answer of 45.03 without the % sign and without working scored 3 out of 4.

Limitations of ratio analysis

• Based on historical data; the future may differ.
• A single ratio means little; it needs comparisons with past years, competitors and industry norms, and businesses may use different accounting policies.
• Figures at one date may be unrepresentative, or window dressed to look better.
• Ignores qualitative factors: brand, staff morale, management quality, the economy, new competitors.
• Inflation distorts comparisons over time.
• Ratios show symptoms, not causes; further investigation is needed.

Worked example

A business has current assets of $45,000, of which $18,000 is inventory, and current liabilities of $36,000. Calculate both liquidity ratios and comment.

1. Current ratio = 45,000 / 36,000 = 1.25.
2. Acid test = (45,000 - 18,000) / 36,000 = 0.75.
3. The current ratio looks acceptable, but without inventory the business cannot cover its short-term debts; it depends on selling stock to pay its bills, which is risky if stock is slow-moving.

Answer: Current ratio 1.25; acid test 0.75: liquidity relies heavily on inventory.

Check yourself

1. Current assets are $84,000 and current liabilities are $56,000. Calculate the current ratio.
   Show answer

   1.50. 84,000 / 56,000 = 1.50.

2. October 2024 WBS13: current assets 218 trillion won; current liabilities 78 trillion won. Calculate the current ratio to 2 decimal places.
   Show answer

   2.79. 218 / 78 = 2.79.

3. Current assets are $84,000 including inventory of $35,000. Current liabilities are $56,000. Calculate the acid test ratio to 2 decimal places.
   Show answer

   0.88. (84,000 - 35,000) / 56,000 = 0.88.

4. January 2025 WBS13: non-current liabilities EUR1,752m; capital employed EUR3,891m. Calculate the gearing ratio to 2 decimal places.
   Show answer

   45.03 %. 1,752 / 3,891 x 100 = 45.03%.

5. Non-current liabilities are $1.2m and total equity is $1.8m. Calculate the gearing ratio.
   Show answer

   40.00 %. Capital employed = 1.2 + 1.8 = 3.0. Gearing = 1.2 / 3.0 x 100 = 40%.

6. Why is inventory excluded from the acid test ratio?
   • It may not be possible to turn it into cash quickly
   • It is a non-current asset
   • It is a liability
   • It never changes in value
   Show answer

   It may not be possible to turn it into cash quickly. Stock may be slow to sell or have to be sold at a discount.

7. Which is the main risk of high gearing?
   • The owners lose control to new shareholders
   • Inventory levels rise
   • Interest payments become hard to meet if interest rates rise or profits fall
   • The gross profit margin falls
   Show answer

   Interest payments become hard to meet if interest rates rise or profits fall. Debt brings fixed interest obligations.

8. Explain one limitation of using ratio analysis to make business decisions.
   Show answer

   Ratios are based on historical data and ignore qualitative factors such as staff morale or the economy, so they may not predict future performance; they also need comparison with other years or competitors to be meaningful.. Name a limitation and its consequence for decisions.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Business specification (XBS11/YBS11, 2018), Unit 3 Business decisions and strategy and Appendices 6, 7 and 9
• Pearson Edexcel IAL Business WBS13/01 mark scheme, October 2024
• Pearson Edexcel IAL Business WBS13/01 mark scheme, January 2025

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