Calculate and interpret liquidity ratios (current ratio, quick ratio) and efficiency ratios (inventory turnover, accounts receivable turnover) to assess short-term financial health

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.