In part two of our Evaluating Liquidity blog, we apply the definitions and techniques discussed in part one. If you haven’t already done so, be sure to read Evaluating Liquidity - Part One, where we outline the key measures of liquidity and their underlying significance.
Liquidity is an important aspect of financial performance. In the following worked example, we analyse the trend in liquidity of a business over a two-year period.
Worked Example - Liquidity Over Time
Suppose a business observed the following trends in its liquidity ratios over the past two years:
| Metric | 2022 | 2023 |
|---|---|---|
| Working Capital Ratio | 1.5:1 | 3.5:1 |
| Quick Asset Ratio | 1:1 | 0.75:1 |
| Cash Flow Cover | 3 times | 2 times |
What judgement can we make about the business’s liquidity performance over this period? Typically, the judgement needs to be nuanced. Questions are designed such that liquidity is not unambiguously better or worse than it was previously. Typically, liquidity has improved in some respects but has worsened in others.
Such is the case in this example. The working capital ratio has increased from 1.5:1 to 3.5:1. This indicates that, for every dollar in current liabilities, the business has gone from having $1.50 in current assets in 2022 to $3.50 in current assets in 2023. This means the business is in a better position to service its current liabilities using its current assets and suggests that the business can more comfortably meet its short-term debts when they fall due.
However, the business has observed a deterioration in its quick asset ratio, which has fallen from 1:1 to 0.75:1. The fact that the quick asset ratio is now below 1:1 indicates that the business is unable to fully pay for its immediate short-term debt obligations using its liquid assets. The business will therefore have to seek out alternative sources of finance to meet these obligations, such as contributions from the owner or, in more serious circumstances, temporary external finance.
Furthermore, we observe a stark divergence between the working capital ratio, which improved, and the quick asset ratio, which deteriorated. This is significant. Given that the difference between the two ratios is the sum of inventory and prepaid expenses, this suggests that the business may be accumulating excess inventory, representing an inefficient allocation of resources.
Moreover, the business’s cash flow cover has declined from 3 times in 2022 to 2 times in 2023, indicating that net cash flows from operating activities - the primary day-to-day trading activities of the business - are now only twice the value of average current liabilities. This suggests that the business is still able to meet its short-term debts when they fall due using cash generated from its primary operations but may have difficulty doing so if the cash flow cover continues to deteriorate. Nonetheless, the fact that the cash flow cover is above 1 assures the self-sufficiency of this business - the business is able to use cash it generates from its primary function as a business to directly fund short-term debt payments.
Is the analysis different when we compare two different businesses?
A comparison of liquidity performance between two businesses at a point in time is analogous to comparing one business over two points in time. The comparative tone and techniques we employ are nearly identical. We need only modify our tone from one that describes changes over time to differences between businesses.
| Metric | Business A | Business B |
|---|---|---|
| Working Capital Ratio | 1.5:1 | 3.5:1 |
| Quick Asset Ratio | 1:1 | 0.75:1 |
| Cash Flow Cover | 3 times | 2 times |
The substance of the analysis is identical. We need only adjust our tone to compare two businesses, rather than two periods. We would make our remarks with this in mind. For instance, rather than describing a decline in the cash flow cover, we would explain that business A has a stronger cash flow cover ratio than business B.
Next time: Profitability Analysis
This concludes our two-part blog on evaluating liquidity. Be sure to check out Evaluating Liquidity - Part One. In the next blog, we will learn how to analyse the profitability of a business using key accounting ratios and profitability margins.
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FAQs
Understand what each ratio measures—Working Capital Ratio (overall short-term cover), Quick Asset Ratio (immediate cover excluding inventory and prepayments), and Cash Flow Cover (ability to pay short-term debts from operating cash). Then compare across periods or between businesses and explain the drivers of any change (e.g. inventory growth, slower collections, higher payables).
It shows whether a business can meet immediate short-term debts using liquid assets. A ratio below 1:1 suggests potential cash-tightness without selling inventory or arranging short-term finance.
Investigate operating cash drivers: collections from debtors, inventory turnover, and expense control. Improve working capital efficiency (faster receivables, leaner inventory, prudent payables), reduce unnecessary costs, and stabilise revenue.
Not necessarily. Very high WCRs can signal idle current assets (e.g. excess inventory). Balance is key—pair WCR with QAR and Cash Flow Cover to judge quality, not just quantity, of liquidity.
Many students benefit from targeted feedback on ratio interpretation, trend statements, and exam-style explanations. A tutor can help you write concise, high-scoring analysis and avoid common pitfalls in SACs and the exam.
