Ratio Analysis: Liquidity, Efficiency and Gearing Ratios
Ratio analysis converts figures from a business's financial statements into standardised measures that can be compared over time or against competitors. Liquidity ratios, such as the current ratio (current assets divided by current liabilities) and the acid test ratio (current assets minus inventory, divided by current liabilities), measure whether a business can pay its short-term debts. Efficiency ratios, such as inventory turnover and the payables/receivables days, measure how well a business manages its working capital and assets. Gearing measures the proportion of a business's capital that comes from debt rather than equity, calculated as non-current liabilities divided by capital employed, multiplied by 100, and is used to judge financial risk: a highly geared business faces larger fixed interest payments, which increases risk if profits or cash flow fall.
Before you start
Make sure you're comfortable with these topics first:
Method
- Learn the exact formula for each required ratio, since an examiner accepts a correctly labelled calculation even without a memorised definition: current ratio = current assets / current liabilities; acid test = (current assets - inventory) / current liabilities; gearing = (non-current liabilities / capital employed) x 100.
- Group ratios by what they measure before analysing them: liquidity (short-term solvency), efficiency (how well working capital and assets are used) and gearing (long-term financial risk from debt), so an analysis answer targets the right explanation for the right number.
- Always state the general benchmark alongside the calculated figure, e.g. a current ratio noticeably below 1.5 to 2 can signal a liquidity problem, and gearing above roughly 50% is usually described as highly geared, then judge the actual figure against that benchmark rather than quoting the benchmark alone.
- Compare a ratio across two time periods or against a rival's figure wherever the case provides one, since a single year's ratio in isolation supports a weaker analytical point than a trend or comparison.
- Link a ratio result to a plausible underlying cause or consequence named in the case, e.g. rising gearing following a debt-funded expansion, or falling inventory turnover following weaker sales, rather than stating the number without interpretation.
- For an evaluate question, weigh what the ratios show against non-financial context in the case (market conditions, strategy, timing of the data) before reaching a supported judgement, since ratios describe past performance and do not by themselves prove future risk or success.
Worked example
A company reports current assets of 180,000 pounds, of which 60,000 pounds is inventory, and current liabilities of 90,000 pounds. Its non-current liabilities are 250,000 pounds and its total capital employed is 500,000 pounds. Calculate the current ratio, the acid test ratio and the gearing ratio, and comment on the business's liquidity and financial risk.
- Calculate the current ratio: current assets / current liabilities = 180,000 / 90,000 = 2:1.
- Calculate the acid test ratio: (current assets - inventory) / current liabilities = (180,000 - 60,000) / 90,000 = 120,000 / 90,000 = 1.33:1.
- Calculate the gearing ratio: (non-current liabilities / capital employed) x 100 = (250,000 / 500,000) x 100 = 50%.
- Interpret liquidity: a current ratio of 2:1 and an acid test of 1.33:1 are both at or above the typical benchmark range, suggesting the business can comfortably cover its short-term liabilities even without selling inventory.
- Interpret gearing: a gearing ratio of exactly 50% sits at the usual threshold for 'highly geared', so half of the business's capital comes from debt carrying fixed interest obligations, which is a moderate level of long-term financial risk rather than a low one.
Practice questions
Try each question, then tap to reveal the answer.
Q1State the formula for the current ratio.Show answer
Answer: Current assets divided by current liabilities.
Q2A business has current assets of 40,000 pounds and current liabilities of 20,000 pounds. Calculate the current ratio.Show answer
Answer: 40,000 / 20,000 = 2:1.
Q3State the formula for the gearing ratio.Show answer
Answer: Non-current liabilities divided by capital employed, multiplied by 100.
Q4A business has non-current liabilities of 300,000 pounds and capital employed of 400,000 pounds. Calculate the gearing ratio and state whether the business is highly geared.Show answer
Answer: (300,000 / 400,000) x 100 = 75%. Yes, this is highly geared, since it is well above the usual 50% benchmark.
Q5Explain why the acid test ratio excludes inventory when the current ratio does not.Show answer
Answer: Inventory can be slow or difficult to convert into cash quickly, so excluding it from the acid test gives a stricter, more cautious measure of a business's ability to meet its immediate short-term debts.
Q6Give one reason a business's gearing ratio might rise significantly in a single year.Show answer
Answer: For example, taking out a large new bank loan or issuing debentures to fund expansion, which increases non-current liabilities relative to capital employed.
Q7State one limitation of comparing ratios between two different businesses.Show answer
Answer: Differences in size, industry, or accounting policy between the businesses can make a direct comparison misleading unless they are genuinely similar.
Q8A business has current assets of 150,000 pounds, of which 90,000 pounds is inventory, and current liabilities of 60,000 pounds. Calculate the acid test ratio.Show answer
Answer: (150,000 - 90,000) / 60,000 = 60,000 / 60,000 = 1:1.
Exam-style questions
Written in the style of a A Level Business exam paper, with a full mark scheme.
A retailer's current ratio has fallen from 2.2:1 last year to 1.1:1 this year, while its acid test ratio has fallen from 1.4:1 to 0.5:1 over the same period. Analyse what these changes suggest about the retailer's liquidity position.
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Two years ago, Halvorsen Furniture had a current ratio of 1.9:1, an acid test ratio of 1.0:1 and a gearing ratio of 30%. This year, after borrowing 400,000 pounds to fund a new warehouse, its current ratio is 1.3:1, its acid test ratio is 0.6:1 and its gearing ratio is 58%. Revenue has grown by 12% over the same two years, and the finance director says the warehouse will cut delivery costs by 150,000 pounds a year once fully operational next year. Evaluate whether Halvorsen Furniture's financial position has improved over the two years.
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Free printable worksheet
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