Current Ratio (a liquidity ratio)

A firm needs liquid assets to meet day to day payments. Therefore, liquidity ratios highlight the ability of the firms to convert its assets into cash. If the ratios are low then it means that money is tied up in stocks and debtors. Thus, money is not available to make payments. This may cause considerable problems for firms in the short run. It is often thought that a value less than 1.5 implies that the company may run out of money as its cash is tied up in unproductive assets.

The current ratio shows the relationship between the current assets and the current liabilities.

Current ratio = current assets / current liabilities

Acid Test Ratio (a liquidity ratio)

The acid test ratio is similar to the current ratio as it highlights the liquidity of the company. A ratio of 1:1 (i.e. a value of approximately 1) is satisfactory. However, if the value is significantly less than 1 it implies that the company has a large amount of its cash tied up in unproductive assets, so the company may struggle to raise money in the short term.

Acid test ratio = (current assets - stock) / current liabilities

Gearing Ratio (a gearing ratio)

The gearing ratio allows you to examine the capital structure of the company. It summarises the proportion of debt (loans etc.) and equity (from shareholders).

A ratio that is greater than 100 percent this implies that the company has a high degree of leverage (high gearing). This can be interpreted as the company is taking risks through having a high level of debt compared to its equity.

Gearing ratio = (loan capital + preference share capital) / (total capital (loan + preference + equity))

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