a) Year 2 Current Ratio = 700 / 300 = 2.33 : 1
Year 1 Current Ratio = 500 / 200 = 2.5 : 1
Year 2 Acid Test = (700 - 350) / 300 = 1.17 : 1
Year 1 Acid Test = (500 - 250) / 200 = 1.25 : 1 [4 marks]
b) JKL's liquidity position is pretty favourable. In both years, the current ratio shows that there is enough working capital in the firm, e.g. in Year 2 for every $1 of current liability, JKL has $2.33 of current assets. The slight fall in the ratio is not necessarily suggestive of poorer liquidity since too high a current ratio means the firm is not using its resources efficiently (such as holding too much cash). Likewise, the acid test reveals that JKL's liquidity is favourable since it exceeds the recommended minimum of ratio of 1:1 (textiles stocks are likely to be quite liquid), although the figures have somewhat deteriorated.
c) Consideration of any two factors for maximum marks. a few of the issues might include:
• JKL's cash holdings have increased by 300%; this might help to enhance liquidity but there is a possible large opportunity cost in holding too much cash.
• Stocks have as well increased, thereby reducing the value of the acid test in Year 2. Further information on the type of stock is need, such as whether most of the stock is work-in-progress or finished stocks. It might also be helpful to know the stock turnover, i.e. how fast the firm sells its products (high stock turnover may signify that the current ratio can be symptomatic of the firm's liquidity position).
• JKL Ltd. will also want to investigate the cause of the 50% increase in its short-term liabilities, such as creditors and overdrafts, which have condensed its liquidity ratios.
• The relationship with debtors and suppliers can also give some within reach to the liquidity position of the firm. Suppliers are more probable to grant credit if there is a good professional relationship and Debtors are more likely to pay on time.