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Liquidity ratios are used to assist in managing a business - Leaving Cert Business - Question C - 2007

Question C

Liquidity ratios are used to assist in managing a business. Name two of these ratios and describe their respective benefits.

Worked Solution & Example Answer:Liquidity ratios are used to assist in managing a business - Leaving Cert Business - Question C - 2007

Step 1

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Answer

The Working Capital Ratio is calculated as:

$\text{Working Capital Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$

Benefits:

This ratio helps assess a company's short-term financial health and its ability to cover short-term liabilities with short-term assets.
A higher ratio indicates better liquidity, which suggests that the business can easily meet its obligations, making it attractive to creditors and investors.

Step 2

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Answer

The Acid Test Ratio is calculated as:

$\text{Acid Test Ratio} = \frac{\text{Current Assets} - \text{Closing Stock}}{\text{Current Liabilities}}$

Benefits:

This ratio provides a more stringent measure of liquidity by excluding inventory from current assets, as inventory may not be readily convertible to cash.
A ratio of 1 or higher generally indicates that the business can pay off its current liabilities without selling inventory, reflecting strong financial stability.

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