Liquidity and Gearing Ratios WACE Accounting and Finance Unit 4
“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”
Liquidity ratios measure whether a business can pay its short-term debts. The current ratio compares current assets with current liabilities; the quick ratio strips out inventory to test the most liquid assets. Gearing (stability) ratios measure reliance on borrowed funds: the debt to equity ratio compares total liabilities with equity, and the equity ratio shows the proportion of assets funded by owners. High gearing raises both risk and potential return.
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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
Current ratio = Current assets / Current liabilities
Quick ratio = (Current assets - Inventory) / Current liabilities
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.
A current ratio above 1 means current assets exceed current liabilities, so the business can cover its short-term debts. A very high ratio is not always good, as it may mean idle cash or excess inventory that could be working harder. The quick ratio matters most for businesses holding large, slow-moving stock, where the current ratio alone could overstate the ability to pay.
Gearing and stability ratios
Debt to equity ratio = Total liabilities / Total equity x 100
Equity ratio = Total equity / Total assets x 100
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.
Higher gearing magnifies returns to owners when the business earns more on borrowed funds than the interest it pays, but it also magnifies losses and raises the risk of being unable to meet interest and repayments. A highly geared business is more vulnerable in a downturn, while a low-geared business is more stable but may be forgoing growth. Lenders and investors read these ratios to judge financial risk.
Brae Ltd reports current assets $150 000 (including inventory $60 000), current liabilities $75 000, total liabilities $200 000, total equity $300 000 and total assets $500 000.
Current ratio:
Quick ratio:
Debt to equity:
Equity ratio:
The current ratio of 2.0 and quick ratio of 1.2 both exceed 1, so short-term solvency is sound even without relying on inventory. With 60 per cent of assets funded by owners and debt at two-thirds of equity, gearing is moderate, leaving the business reasonably stable while still using some borrowings.
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.
The quick ratio exists precisely to exclude inventory, because stock can be slow or uncertain to convert into cash. Students sometimes compute it the same way as the current ratio, which defeats its purpose. Always subtract inventory (and any prepayments) from current assets before dividing by current liabilities.
Exam-style questions
Questions in the style of SCSA 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.
WACE 2022-style8 marksMarne Ltd reports current assets $240 000 (inventory $90 000), current liabilities $120 000, total liabilities $360 000, total equity $440 000 and total assets $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 2023-style5 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.