How do liquidity and gearing ratios measure whether a business can pay its short-term debts and how heavily it relies on borrowed funds?
Calculate and interpret the current ratio, quick ratio, debt to equity and equity ratio, and explain what they reveal about short-term solvency and financial stability
WACE Year 12 Accounting and Finance Unit 4 on liquidity and gearing: the current ratio and quick ratio for short-term solvency, and the debt to equity and equity ratios for financial stability, with calculation and interpretation of each.
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What this dot point is asking
SCSA wants you to calculate each ratio, interpret short-term solvency and long-term stability, and weigh the trade-offs of gearing.
Liquidity ratios
The current ratio shows how many dollars of current assets back each dollar of current liabilities. The quick ratio (acid test) removes inventory, which can be slow to convert to cash, giving a stricter view of immediate solvency.
Gearing and stability ratios
The debt to equity ratio shows borrowed funds relative to owners' funds. The equity ratio shows what share of assets is financed by owners rather than creditors, so a higher equity ratio means greater stability.
The two stability ratios are linked: because assets are financed by either liabilities or equity, the equity ratio and a debt-to-assets ratio always sum to 100 per cent. A business with an equity ratio of 55 per cent therefore funds 45 per cent of its assets with debt. Reading the debt to equity ratio alongside the equity ratio gives a complete picture of the capital structure: one frames borrowings against owners' funds, the other frames owners' funds against the whole asset base. Lenders watch these closely, because a heavily geared business has less of a buffer to absorb losses before creditors are at risk, and it must meet fixed interest payments regardless of how profitable the year turns out to be.
Why liquidity and stability are different questions
It is worth keeping liquidity and gearing distinct, because they answer different questions and a business can score well on one and poorly on the other. Liquidity is a short-term question: can the business meet its debts as they fall due over the next twelve months? It is answered by comparing current assets with current liabilities. Gearing (stability) is a long-term question: how is the business financed, and how exposed is it to the risks of debt? It is answered by comparing borrowings with equity or with total assets. A highly profitable business can still face a liquidity crisis if its cash is tied up in slow-moving stock or overdue debtors, and a business with healthy current ratios can still be financially fragile if it is heavily geared and a downturn threatens its ability to service interest. Reading the two families together, rather than in isolation, gives a fuller picture of financial health.
Exam-style practice questions
Practice questions written in the style of SCSA exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.
WACE 20228 marksMarne Ltd reports current assets 90 000), current liabilities 360 000, total equity 800 000. Calculate the current ratio, quick ratio, debt to equity ratio and equity ratio, and comment on the company's short-term solvency and gearing.Show worked answer →
An 8 mark response needs the four ratios and an interpretation.
Current ratio. to 1.
Quick ratio. to 1.
Debt to equity. .
Equity ratio. .
Comment. Both the current ratio (2.0) and quick ratio (1.25) exceed 1, so short-term solvency is sound even without relying on inventory. With 55 per cent of assets funded by owners and debt at about 82 per cent of equity, gearing is moderate to slightly high, manageable while profits cover interest but a point to watch in a downturn. Markers reward all four ratios with correct formulas and a comment on both solvency and gearing.
WACE 20235 marksExplain the trade-off a business faces from increasing its gearing, and explain why the quick ratio can give a more useful picture of liquidity than the current ratio for some businesses.Show worked answer →
A 5 mark response needs the gearing trade-off and the quick-ratio point.
Gearing trade-off. Higher gearing magnifies returns to owners when the business earns more on borrowed funds than the interest it pays, lifting return on equity. But it also magnifies losses and raises the risk of being unable to meet interest and repayments, especially in a downturn. More debt means more potential return and more risk.
Quick ratio. The quick ratio excludes inventory because stock can be slow or uncertain to convert into cash. For a business holding large, slow-moving inventory, the current ratio can overstate the ability to pay immediate debts, while the quick ratio gives a stricter, more realistic view of liquidity. Markers reward the return-versus-risk trade-off and the reason for excluding inventory.