Liquidity Ratios The two ratios most commonly used to assess a company's liquidity position are the current ratio and the quick ratio (otherwise known as the acid test). They are both concerned with the ability of a firm to cover its short-term liabilities from those assets which the working capital cycle will turn into liquid form in the short term. Current ratio Unfortunately, the current ratio can never give more than a very broad indication of a company's short-term financial position. There cannot be a 'norm' for the ratio below which a danger signal is sounded. Manufacturers could be expected to have higher ratios than high-street retailers, simply because of the sheer length of the working capital cycle in the case of the former, and the financing of stocks through creditors, coupled with the relative absence of debtors, in that of the latter. Rather than indicating increasing financial strength or liquidity, a high or increasing current ratio may indicate poor or deteriorating credit control, or an unwelcome build-up of stocks that will prove expensive to finance and difficult to sell. Again, because companies may prefer to have their year end at a time which is most convenient to them in terms of low activity and stock levels, balance sheet ratios will not reflect the typical situation, and a completely different picture might be observed if the following month's management accounts were used for the calculation of the current ratio. We must also recognize that the composition of creditors falling due within one year' could range from 100 per cent items that are due on the first day of the following financial year, to 100 per cent items that are due exactly 12 months less a day from the present balance sheet date: both extremes would present current liabilities for the purposes of the current ratio calculation, but there is obviously a vast difference in their real impact on a company's short-term financial position. Finally, an extreme example will illustrate the susceptibility of the current ratio (and the quick ratio, seen in 13.2.2), to 'window dressing: Example Extract from balance sheet The current ratio is 22,000/11,000 = 2. Suppose the company uses the cash to pay off €10.000 of the current liabilities. This would have the dramatic effect of increasing the current ratio from 2 to 12: No accountant would argue that this increase represents an improvement in the company's financial position, despite the inferences which might be drawn from a superficial analysis. Lewis et al. (1981) have pointed out the simple mathematical basis for this form of 'window dressing' - if a ratio is greater than 1, the subtraction of the same amount from both numerator and denominator will make the ratio larger: if A/B > 1, then (A- x)/(B-x) > A/B. Conversely, if the initial ratio is less than 1, it would become smaller as a result of this action: if A/B <1, then (A-x)/(B- x) < A/B. [B>x>0].