A company can be highly profitable and still fail if it cannot pay its bills on time, or if it has borrowed so much that interest swallows its profit. Two groups of ratios look at these risks. Liquidity ratios test whether the company can meet its short-term obligations.
Long-term stability ratios, also called gearing or capital structure ratios, test how much of the business is financed by debt and whether it can carry that debt.
This topic completes ratio analysis. It follows profitability and efficiency, and it shows how to compare a company across two years and judge whether each ratio improved or weakened. Several figures in a widely used version of the comparative example do not agree with its own formulas, so this page gives the corrected values. The next topic starts partnership accounts.
In 30 seconds
Current ratio = current assets ÷ current liabilities. Quick ratio = (current assets − inventory) ÷ current liabilities. Cash ratio = cash and equivalents ÷ current liabilities. Working capital = current assets − current liabilities. Debt-to-equity = total debt ÷ total equity. Interest cover = EBIT ÷ interest. Long-term debt to capitalisation = long-term debt ÷ (long-term debt + equity). Long-term debt to total assets = long-term debt ÷ total assets. Higher liquidity ratios mean safer short-term cover, but a very high current ratio can mean idle assets.
Higher gearing and lower interest cover mean more risk. Always compare with last year and say whether each ratio improved or weakened.
Liquidity ratios
Liquidity ratios assess whether the company has enough liquid assets to pay its short-term debts as they fall due, so that it does not need new financing. Management uses them to manage working capital, and lenders and suppliers use them before extending credit.
| Ratio | Formula | Meaning |
|---|---|---|
| Current ratio | Current assets ÷ current liabilities | Cover of short-term obligations by all current assets. Very high values may signal inefficient use of assets. |
| Quick (acid-test) ratio | (Current assets − inventory) ÷ current liabilities | Cover without relying on inventory, which may be slow to convert into cash. |
| Cash ratio | Cash and cash equivalents ÷ current liabilities | The most conservative measure, using only the most liquid assets. |
Current assets are cash, receivables, inventory and prepaid expenses. Current liabilities are payables, short-term loans, tax payable and accrued expenses. Some analysts also exclude prepayments from the quick ratio. Working capital is current assets less current liabilities. For example, with cash of ₦3,000, inventory ₦29,000 and receivables ₦35,000 (all ₦’000), current assets are 67,000. With payables of 50,000, working capital is ₦17,000 (November Diet 2019, Section A, Questions 9 and 10).
Illustration (XYZ Ltd). Current assets ₦5,000,000 (including inventory ₦1,500,000 and cash ₦1,000,000) and current liabilities ₦2,000,000.
| Ratio | Working | Result |
|---|---|---|
| Current ratio | 5,000,000 ÷ 2,000,000 | 2.5 : 1 |
| Quick ratio | (5,000,000 − 1,500,000) ÷ 2,000,000 | 1.75 : 1 |
| Cash ratio | 1,000,000 ÷ 2,000,000 | 0.5 : 1 |
The cash conversion cycle and liquidity. A shorter cycle improves liquidity, reduces the need for short-term financing, and gives more room to invest and more financial flexibility. A longer cycle does the opposite.
Long-term stability (gearing) ratios
These show how much of the capital structure is debt and how much is equity, whether the company can sustain its borrowing, and how risky it is to lend to or invest in.
| Ratio | Formula | Higher means |
|---|---|---|
| Debt-to-equity | Total debt (long-term + short-term) ÷ total equity | More leverage and more risk |
| Interest cover | EBIT ÷ interest, where EBIT = net profit + interest + tax | Interest is covered more easily |
| Long-term debt to capitalisation | Long-term debt ÷ (long-term debt + equity) | More reliance on long-term debt |
| Long-term debt to total assets | Long-term debt ÷ total assets | More of the assets financed by long-term debt |
Illustration (ABC Ltd). Profit after tax ₦2,800,000, interest ₦1,000,000, tax ₦1,200,000, current liabilities ₦2,000,000, long-term debt ₦8,000,000, share capital ₦12,000,000, reserves ₦8,000,000, current assets ₦7,200,000 and non-current assets ₦22,800,000.
| Ratio | Working | Result |
|---|---|---|
| Debt-to-equity | (8,000,000 + 2,000,000) ÷ 20,000,000 | 0.5 : 1 |
| Interest cover | (2,800,000 + 1,000,000 + 1,200,000) ÷ 1,000,000 | 5 times |
| Long-term debt to capitalisation | 8,000,000 ÷ (8,000,000 + 20,000,000) | 28.6% |
| Long-term debt to total assets | 8,000,000 ÷ 30,000,000 | 26.7% |
Debt is half of equity, interest is covered five times, and just over a quarter of long-term capital is borrowed. The company is mainly equity-financed.
Comparative analysis
Looking at one year is not enough. Comparing statements over several years reveals trends, shows whether performance is improving, helps explain big changes, and supports budgeting and decisions. For each ratio, state the two values and whether it improved or weakened.
Example (XYZ Ltd). Revenue ₦200,000,000 (2024) and ₦150,000,000 (2023); cost of sales 120,000 and 90,000; operating expenses 40,000 and 30,000; interest 7,000 and 5,000; tax 4,600 and 3,200; profit 28,400 and 21,800 (all ₦’000). Total assets 320,000 and 250,000 (with non-current assets 220,000 and 170,000); current assets 100,000 and 80,000; equity 160,000 and 130,000; non-current liabilities 100,000 and 80,000; current liabilities 60,000 and 40,000. Further: cash 30,000, 20,000 and 15,000; inventory 40,000, 30,000 and 25,000 (2024, 2023, 2022); 2022 current assets 60,000, current liabilities 30,000 and total assets 210,000.
| Ratio | 2024 | 2023 | Change |
|---|---|---|---|
| Gross profit margin | 40.0% | 40.0% | No change |
| Operating margin | 20.0% | 20.0% | No change |
| Net profit margin | 14.2% | 14.5% | Slightly weaker |
| Return on capital employed (ROCE) (PBIT ÷ capital employed) | 15.4% | 14.3% | Improved |
| Return on equity (ROE) | 17.8% | 16.8% | Improved |
| Inventory turnover | 3.43 | 3.27 | Improved |
| Receivables turnover | 6.67 | 6.00 | Improved |
| Payables turnover | 2.60 | 2.71 | Slower payment |
| Asset turnover | 0.70 | 0.65 | Improved |
| Working capital turnover | 5.00 | 4.29 | Improved |
| Operating cycle (days) | 161.1 | 172.4 | Shorter |
| Cash conversion cycle (days) | 20.7 | 37.7 | Shorter |
| Current ratio | 1.67 | 2.00 | Weaker |
| Quick ratio | 1.00 | 1.25 | Weaker |
| Cash ratio | 0.50 | 0.50 | No change |
| Debt-to-equity | 1.00 | 0.92 | More geared |
| Interest cover | 5.71 | 6.00 | Weaker |
| Long-term debt to capitalisation | 38.5% | 38.1% | Slightly higher |
The picture is of a business that is using its assets and working capital more efficiently and converting inventory and receivables to cash faster, but whose liquidity and cover have weakened, with the extra funding coming from more borrowing and from suppliers. Receivables were found as current assets less inventory less cash. Credit purchases are cost of sales plus the increase in inventory. Average balances were used.
Benefits and limitations of ratio analysis
Benefits. Ratios simplify complex data, make comparison possible between companies, industries and periods, point to strengths and weaknesses so managers can act, give insight into profitability, liquidity and solvency, and support decisions.
Limitations. Ratios ignore qualitative factors such as management quality and market conditions. They can mislead when data is incomplete or wrong. Companies with different accounting policies are hard to compare. They ignore inflation and external factors, rely on historical data and say little about the future, can be manipulated by management, and need expertise to interpret.
The ideas in more depth
Corrections to the comparison. The worked solution in a widely used version has figures that disagree with the formulas. Its ROCE working divides profit after tax by capital employed (10.9% and 10.4%) and its summary table shows 14.04% and 10.53%. But the formula is profit before interest and tax divided by total assets less current liabilities: 40,000 ÷ (320,000 − 60,000) = 15.4% and 30,000 ÷ (250,000 − 40,000) = 14.3%. The ROE table shows 19.59% and 15.03%, but the working gives 28,400 ÷ 160,000 = 17.75% and 21,800 ÷ 130,000 = 16.77%, which are the figures used above.
The 2023 working capital turnover uses working capital of 30,000, but the average of 40,000 and 30,000 is 35,000, so it is 4.29, not 5.00, and the 2024 figure of 5.00 is therefore an improvement. The cash ratio working has typing errors (₦300,000 and ₦600,000 for ₦30,000 and ₦60,000), though the result of 0.5 is right.
Background. A current ratio of about 2:1 is often quoted as healthy, but what is normal depends on the industry. A supermarket sells inventory quickly for cash and can run with a lower ratio than a manufacturer. Gearing is a risk because interest is a fixed charge, while dividends are not. Interest cover shows how far profit could fall before interest is not covered.
Worked example: Ibadan Chemicals Ltd
Scenario. Ibadan Chemicals Ltd reports (₦000), year 2 then year 1: inventory 90 and 70; receivables 110 and 100; cash 20 and 30; payables 100 and 70; other current liabilities 40 and 30; long-term loan 200 and 150; equity 400 and 350. Profit before interest and tax is 90 and 80, and interest is 30 and 18. Required: the liquidity and gearing ratios for both years, with a comment.
| Ratio | Year 2 | Year 1 |
|---|---|---|
| Current assets | 220 | 200 |
| Current liabilities | 140 | 100 |
| Current ratio | 1.57 | 2.00 |
| Quick ratio | (220 − 90) ÷ 140 = 0.93 | (200 − 70) ÷ 100 = 1.30 |
| Cash ratio | 0.14 | 0.30 |
| Debt-to-equity | (200 + 140) ÷ 400 = 0.85 | (150 + 100) ÷ 350 = 0.71 |
| Long-term debt to capitalisation | 200 ÷ 600 = 33.3% | 150 ÷ 500 = 30.0% |
| Interest cover | 90 ÷ 30 = 3.0 times | 80 ÷ 18 = 4.4 times |
Comment. Liquidity has weakened sharply. The current ratio fell from 2.00 to 1.57, the quick ratio dropped below 1 and the cash ratio fell to 0.14, so the company would struggle to pay current liabilities without selling inventory or collecting receivables. Gearing is higher, because the loan and short-term liabilities have grown faster than equity. Interest cover has fallen from 4.4 to 3.0 times because borrowing and interest rose while operating profit barely moved. The company is more exposed to a downturn.
Common mistakes in the exam
- Leaving inventory in the quick ratio, or taking prepayments as quick assets without saying so.
- Using profit after tax for interest cover instead of EBIT.
- Dividing long-term debt by equity alone, when the capitalisation ratio uses debt plus equity.
- Calling a higher current ratio always good.
- Not saying whether each ratio improved or weakened between the years.
- Using different bases for the two years, such as averages in one and closing figures in the other.
- Describing the ratio instead of what it means for the business.
- Forgetting the limitations of ratio analysis in an “advise the owner” answer.
Quick revision
- Liquidity: current, quick and cash ratio. Working capital = current assets − current liabilities.
- Gearing: debt-to-equity, interest cover (EBIT ÷ interest), long-term debt to capitalisation and to total assets.
- Compare years and say improved or weakened.
- Limitations: qualitative factors, accounting policies, history, manipulation.
Practice questions
These are original questions in the style of the Institute of Chartered Accountants of Nigeria (ICAN) exam. Try each one first.
Section A style: multiple choice
Question 1. Current assets are ₦5m and current liabilities ₦2m. The current ratio is:
- 0.4 : 1
- 3 : 1
- 7 : 1
- 2.5 : 1
Show the answer
D. 5 ÷ 2 = 2.5 : 1.
Question 2. The quick ratio excludes:
- Cash
- Inventory
- Receivables
- Nothing
Show the answer
B. Inventory may not convert into cash quickly, so it is excluded.
Question 3. Current assets are ₦5m including inventory of ₦1.5m, and current liabilities are ₦2m. The quick ratio is:
- 1.75 : 1
- 2.5 : 1
- 0.75 : 1
- 3.5 : 1
Show the answer
A. (5 − 1.5) ÷ 2 = 1.75 : 1.
Question 4. Cash is ₦1m and current liabilities ₦2m. The cash ratio is:
- 2 : 1
- 1 : 1
- 0.5 : 1
- 0.2 : 1
Show the answer
C. 1 ÷ 2 = 0.5 : 1.
Question 5. Cash is ₦3,000, inventory ₦29,000 and receivables ₦35,000, and payables are ₦50,000 (all ₦’000). Working capital is:
- ₦30,000
- ₦38,000
- ₦67,000
- ₦17,000
Show the answer
D. Current assets 67,000 less payables 50,000 = 17,000.
Question 6. EBIT is ₦5m and interest ₦1m. Interest cover is:
- 5 times
- 0.2 times
- 4 times
- 6 times
Show the answer
A. 5 ÷ 1 = 5 times.
Question 7. Long-term debt is ₦8m and equity ₦20m. Long-term debt to capitalisation is:
- 40%
- 8%
- 28.6%
- 16%
Show the answer
C. 8 ÷ (8 + 20) = 28.6%.
Question 8. Total debt is ₦10m and total equity ₦20m. The debt-to-equity ratio is:
- 2 : 1
- 0.5 : 1
- 1 : 1
- 0.2 : 1
Show the answer
B. 10 ÷ 20 = 0.5 : 1.
Question 9. Which of these indicates higher financial risk?
- A higher debt-to-equity ratio
- Higher interest cover
- A higher cash ratio
- Fewer inventory days
Show the answer
A. More debt relative to equity means more fixed interest and more risk.
Question 10. Which of these is a limitation of ratio analysis?
- It simplifies complex data
- It allows comparison
- It identifies weaknesses
- It is based on historical data and ignores qualitative factors
Show the answer
D. The other three are benefits. Ratios use past figures and omit qualitative matters.
Section B style: written questions
Question 11 (10 marks). (a) Distinguish the current ratio, quick ratio and cash ratio, giving the formula for each. (6 marks) (b) State four advantages of a shorter cash conversion cycle. (4 marks)
Question 12 (20 marks). Lafia Tiles Ltd reports (₦000), year 2 then year 1:
- inventory 120 and 100
- receivables 150 and 130
- cash 30 and 50
- payables 150 and 110
- tax payable 30 and 20
- long-term loan 250 and 200
- equity 400 and 380
- profit before interest and tax 120 and 110
- interest 50 and 30
(a) Calculate the current ratio, quick ratio, cash ratio, debt-to-equity, long-term debt to capitalisation and interest cover for both years. (12 marks) (b) Comment on the change in liquidity and financial risk. (8 marks)
A further written question
Question 13 (10 marks). (a) State four limitations of ratio analysis. (6 marks) (b) State two benefits of ratio analysis. (4 marks)
Model answers
Show the model answer to Question 11
(a) The current ratio is current assets divided by current liabilities and tests cover by all current assets. The quick ratio is (current assets − inventory) divided by current liabilities and excludes inventory because it may be slow to convert into cash. The cash ratio is cash and cash equivalents divided by current liabilities and uses only the most liquid assets.
(b) Improved liquidity, a reduced need for short-term financing, a greater ability to invest in growth opportunities, and more financial flexibility.
Show the model answer to Question 12
(a) Year 2:
- current assets 300, current liabilities 180.
- Current ratio 1.67.
- Quick ratio (300 − 120) ÷ 180 = 1.00.
- Cash ratio 30 ÷ 180 = 0.17.
- Debt-to-equity (250 + 180) ÷ 400 = 1.08.
- Long-term debt to capitalisation 250 ÷ 650 = 38.5%.
- Interest cover 120 ÷ 50 = 2.4 times.
- Year 1: current assets 280, current liabilities 130.
- Current ratio 2.15.
- Quick ratio (280 − 100) ÷ 130 = 1.38.
- Cash ratio 50 ÷ 130 = 0.38.
- Debt-to-equity (200 + 130) ÷ 380 = 0.87.
- Long-term debt to capitalisation 200 ÷ 580 = 34.5%.
- Interest cover 110 ÷ 30 = 3.7 times.
(b) Liquidity has deteriorated: the current ratio fell from 2.15 to 1.67, the quick ratio from 1.38 to 1.00 and the cash ratio from 0.38 to 0.17, because current liabilities grew faster than current assets and cash fell. Financial risk has risen: the company borrowed more, debt now exceeds equity, and interest cover fell from 3.7 to 2.4 times because interest increased while operating profit rose only a little.
The company is more vulnerable if profits fall or lenders demand repayment.
Show the model answer to Question 13
(a) Any four of:
- ratios ignore qualitative factors such as management quality and market conditions
- they can be misleading if the data is incomplete or wrong
- companies using different accounting policies are hard to compare
- they ignore inflation and other external factors
- they use historical data and give little insight into the future
- they can be manipulated by management
- they need expertise to interpret
(b) Any two of: they simplify complex data; they allow comparison between companies, industries and periods; they identify strengths and weaknesses; they support decision-making.
Pathfinder on Liquidity and gearing ratios and comparative analysis
These are the ICAN Pathfinder questions that test this topic. ICAN owns the questions and the suggested solutions, so we point you to them and do not copy them. Open your Pathfinder, attempt each question under exam conditions, then check your answer against the notes above.
From the previous syllabus. Gives cash, inventory, receivables and payables of a business and asks for the amount of the current assets and for the working capital.
Revise first: Liquidity ratios
The liquidity and gearing ratios are new syllabus items and no past diet asks for them directly. Expect items on the current and quick ratios, interest cover, debt-to-equity and whether a ratio has improved or weakened. Check Section A of every diet you practise.
Revise first: Long-term stability (gearing) ratios
Questions on the interpretation of financial statements for lenders, investors and managers are likely in the new syllabus. May Diet, 2024 and November Diet, 2023 questions on the needs of stakeholders and the components of financial statements are related.
Revise first: Comparative analysis
Source: ICAN Pathfinder, Financial Accounting. Diets covered: November Diet, 2019, November Diet, 2023 and May Diet, 2024 (the later ones are not all on the previous syllabus). Liquidity and gearing ratios are new syllabus items and no past diet asks for them directly. Diets before November 2014, and November Diet, 2024 onwards, are not covered here.
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