Liquidity and efficiency ratios in QCE Accounting Unit 4
“Calculate and interpret liquidity ratios (current ratio, quick ratio) and efficiency ratios (inventory turnover, accounts receivable turnover) to assess short-term financial health”
Liquidity ratios test whether a business can pay its short-term debts. The current ratio = current assets / current liabilities; a result around 1.5 to 2 is generally healthy. The quick (acid-test) ratio = (current assets - inventory - prepayments) / current liabilities, a tougher test that excludes inventory because it is slower to convert to cash. Efficiency ratios test how well working capital is managed. Inventory turnover = cost of goods sold / average inventory, showing how many times stock is sold and replaced; it can be expressed in days. Accounts receivable turnover = net credit sales / average accounts receivable, showing how quickly customers pay, also expressed in days. Higher turnover usually means tighter, more efficient management of working capital.
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Liquidity can also be tested using cash flows. See cash flow ratios for the operating cash flow ratio, which asks whether trading cash alone can cover current liabilities.
Check against your course. The 2025 QCAA Accounting syllabus describes Unit 4 as the complete accounting processes for a trading GST business and the performance analysis of a public company, with ratios that include EBITDA, earnings per share, price earnings, dividend yield and cash flow ratios. This page covers part of that ground, so check your school's materials for the full list of what is assessed.
What this dot point is asking
QCAA wants you to assess whether a business can meet its short-term obligations and how efficiently it uses its working capital. You must calculate liquidity ratios (current ratio and quick ratio) and efficiency ratios (inventory turnover and accounts receivable turnover), interpret what each reveals, and use the analysis to recommend decisions about managing cash, inventory and receivables.
Liquidity ratios
Liquidity is the ability to pay debts as they fall due in the short term. Two ratios measure it.
Current ratio
Current ratio = Current assets / Current liabilities
This shows how many dollars of current assets cover each dollar of current liabilities. A ratio of 2:1 means the business has $2 of current assets for every $1 of current liabilities. A result around 1.5 to 2 is usually comfortable. Too low risks an inability to pay debts; too high may mean idle cash or excess inventory that could be working harder.
Quick (acid-test) ratio
Quick ratio = (Current assets - Inventory - Prepaid expenses) / Current liabilities
This stricter test removes inventory and prepayments, because inventory must first be sold (and then the receivable collected) before it becomes cash, and prepayments cannot be turned into cash at all. A quick ratio around 1:1 indicates the business can meet short-term debts without relying on selling stock. A business can have a healthy current ratio but a weak quick ratio if it holds a lot of slow-moving inventory.
Efficiency ratios
Efficiency (activity) ratios measure how well the business manages the assets tied up in working capital.
Inventory turnover
Inventory turnover = Cost of goods sold / Average inventory
where average inventory = (opening inventory + closing inventory) / 2.
This shows how many times during the period the business sold and replaced its inventory. A higher turnover means stock sells quickly, freeing cash and reducing holding costs and obsolescence risk. Turnover can be expressed in days: 365 / inventory turnover gives the average number of days stock is held. A low turnover suggests overstocking, slow-moving lines or weak sales.
Accounts receivable turnover
Accounts receivable turnover = Net credit sales / Average accounts receivable
This shows how many times receivables are collected during the period, or in days: 365 / receivable turnover gives the average collection period. A short collection period means customers pay promptly, improving cash flow. A lengthening collection period signals weaker credit control and a rising risk of bad debts, linking back to the allowance for doubtful debts.
Linking liquidity and efficiency
Liquidity and efficiency interact. A business may show an adequate current ratio yet still face a cash shortage if inventory turns slowly and customers pay late, because the current assets are locked up rather than converting to cash. Improving inventory turnover and shortening the collection period strengthens real liquidity more reliably than simply holding more current assets. Decisions that flow from the analysis include tightening credit terms, chasing overdue accounts, clearing slow stock, or negotiating longer supplier terms.
The data
Meadow Wholesalers reports:
Current assets $120,000 (including inventory $50,000 and prepaid expenses $4,000); current liabilities $60,000. Cost of goods sold $360,000; opening inventory $40,000, closing inventory $50,000. Net credit sales $480,000; opening accounts receivable $55,000, closing accounts receivable $65,000.
Current ratio
120,000 / 60,000 = 2.0:1
Quick ratio
(120,000 - 50,000 - 4,000) / 60,000 = 66,000 / 60,000 = 1.1:1
Inventory turnover
Average inventory = (40,000 + 50,000) / 2 = $45,000.
360,000 / 45,000 = 8 times (365 / 8 = about 46 days of stock).
Accounts receivable turnover
Average receivables = (55,000 + 65,000) / 2 = $60,000.
480,000 / 60,000 = 8 times (365 / 8 = about 46 days to collect).
Interpretation
The current ratio of 2.0:1 and quick ratio of 1.1:1 show the business can meet short-term debts even without selling inventory. Inventory turns 8 times a year (about 46 days), and receivables are collected in about 46 days, both reasonable for a wholesaler. To improve cash flow further, the business could tighten credit terms to shorten the 46-day collection period.
- Including inventory in the quick ratio
- The quick ratio deliberately excludes inventory (and prepayments) because they are not quickly convertible to cash.
- Using sales instead of cost of goods sold for inventory turnover
- Inventory turnover compares like with like at cost: cost of goods sold over average inventory.
- Assuming a higher current ratio is always better
- An excessively high ratio can signal idle cash or overstocking; balance matters.
- Using closing balances instead of averages in turnover ratios
- Turnover ratios use average inventory and average receivables across the period.
Exam-style questions
Questions in the style of QCAA exam questions on this dot point, each with a worked answer. They are written by ExamExplained unless tagged "Past paper"; the year shows the paper a question is modelled on.
Practice12 marksRead Case study 3 (Stimulus 4) in the stimulus book. Using four relevant ratios, analyse and interpret the liquidity of The Supermarket Company across the financial years 2022 and 2023. Show your working for the ratio calculations. [Total current assets 221 573 (2022) and 210 465 (2023); total current liabilities 169 305 and 181 996; inventories 124 701 and 130 780; total sales 1 676 801 and 1 256 621; accounts receivable 91 360 and 71 174.]Show worked answer →
Choose four liquidity and working-capital efficiency ratios, show working, then interpret the two-year movement.
Current ratio = current assets / current liabilities:
- 2022 = 221 573 / 169 305 = 1.31:1; 2023 = 210 465 / 181 996 = 1.16:1 (fallen).
Quick (acid-test) ratio = (current assets - inventories - prepayments) / current liabilities:
- 2022 = (221 573 - 124 701) / 169 305 = 0.57:1; 2023 = (210 465 - 130 780 - 2) / 181 996 = 0.44:1 (fallen).
Inventory turnover = cost of goods sold / inventories, where cost of goods sold = sales - gross profit:
- 2022 = 1 512 885 / 124 701 = 12.13 times; 2023 = 1 089 921 / 130 780 = 8.33 times (slower).
Accounts receivable turnover = credit sales / accounts receivable, where credit sales = total sales - cash sales:
- 2022 = (1 676 801 - 725 216) / 91 360 = 951 585 / 91 360 = 10.42 times; 2023 = (1 256 621 - 543 489) / 71 174 = 713 132 / 71 174 = 10.02 times (slightly slower).
Interpretation: every ratio has weakened. The current and quick ratios show a reduced cushion to meet short-term debts (the quick ratio below 1 means the company relies on selling inventory to cover current liabilities), while inventory is turning over more slowly. Overall liquidity has deteriorated from 2022 to 2023. Markers reward four correct ratios with working and a clear interpretation of the decline.
Practice1 markA business is making good profits, but the owners have raised concerns regarding the trend in the turnover of inventory ratio (2021: 4.5 times, 2022: 4.3 times, 2023: 4.0 times; industry benchmark 5.15 times). The data shows that the (A) inventory is slow moving and could affect the business's liquidity. (B) business has strong sales and is making profits, so the trend is not a concern. (C) turnover of inventory ratio is likely to fluctuate from year to year, so is not a concern. (D) trend is not a concern because the turnover ratios are close to the industry benchmark.Show worked answer →
The correct answer is (A) inventory is slow moving and could affect the business's liquidity.
The turnover of inventory ratio measures how many times a year inventory is sold and replaced. A higher figure means inventory sells quickly. Here the ratio is falling year on year (4.5 to 4.3 to 4.0 times) and sits well below the industry benchmark of 5.15 times, so inventory is moving more slowly than competitors and the position is worsening.
Slow-moving inventory ties up cash in stock that is not being converted to sales, which can strain liquidity, so A is correct. B and C dismiss a clear downward trend, and D is wrong because 4.0 times is not close to the 5.15 benchmark.