Short-term Solvency Ratio Analysis

Definition: Short-term solvency ratios are used to measure the ability of a company to meet its short-term financial obligations. These ratios are the Current Ratio and the Acid-Test Ratio. These ratios are vital for ensuring that a company can continue its operations smoothly without facing a liquidity crisis.

The Importance of Short-Term Solvency Ratios

Short-term solvency ratios are a critical component of financial analysis as they help to measure the short-term financial stability of a business. These ratios are particularly important for assessing the company's liquidity, which refers to its ability to pay off its short-term liabilities (debts, obligations) using its short-term assets (cash, receivables, and inventories).

A company’s liquidity is crucial for day-to-day operations. Insufficient liquidity can lead to cash flow problems, preventing the company from paying suppliers, employees, and meeting other financial commitments. On the other hand, having too much liquidity could suggest that a company is not effectively utilizing its assets to generate revenue or growth. Therefore, achieving the right balance is critical for maintaining operational efficiency and financial health.

Formula:
1) Current ratio = Total Current Assets / Total Current Liabilities
2) Acid test ratio = (Current Assets - Inventory) / Current Liabilities

Comparing the Two Ratios: Current Ratio vs. Acid-Test Ratio

While both the Current Ratio and the Acid-Test Ratio measure a company’s short-term solvency, they do so in slightly different ways.

• The Current Ratio offers a broad view of liquidity, considering all current assets (including inventory) against current liabilities.
• The Acid-Test Ratio, on the other hand, takes a more conservative approach, focusing only on the most liquid assets—cash, receivables, and marketable securities.

The key difference lies in the treatment of inventory:

• Current Ratio includes inventory, which may not always be easily convertible to cash.
• Acid-Test Ratio excludes inventory, focusing on assets that can quickly be turned into cash to meet immediate obligations.

In most cases, the acid-test ratio will be lower than the current ratio because it excludes inventory from the equation. However, a company with a very high current ratio and a low acid-test ratio could be over-relying on inventory for liquidity, which could be a potential red flag if inventory is slow-moving or hard to liquidate.

Example:

Use the following information to calculate the relevant short-term solvency ratios:
Trade debtors $12,000
Trade creditors $35,000
Closing inventory $20,000
Cash $18,000
Bank overdraft $5,000

Solution:
Current assets = debtors + inventory + cash = 12,000 + 20,000 + 18,000 = $50,000
Current liabilities = creditors + bank overdraft = 35,000 + 5,000 = $40,000
Current ratio = 50,000 / 40,000 = 1.25
Acid test ratio = (50,000 - 20,000) / 40,000 = 0.75