14. Liquidity Flashcards
What is the distinction between cash and profit?
Cash: money needed for paying day-to-day expenses
Profit : income left over after paying costs
What are the reasons for a distinction between cash and profit?
Business might sell goods on credit, so debtors have to pay the business but later on, therefore profit is greater than cash
Business may buy resources from suppliers and not pay for them till next trading year, therefore its trading costs won’t be the same as cash paid out
Amount of cash at the end of the year will be different from profit because at the beginning of the year the cash balance is likely to be 0
What is the statement of financial position (balance sheet)?
Like a photograph of the financial position of the business at a particular point in time
What does the balance sheet provide a summary of?
- Assets
Resources owned by a business eg. Equiptment, machinery used to make products/provide services - Liabilities
Debts of the business, what it owes to others. Sources of funds for business might be short term —> overdraft or long term —> mortgage - Capital
Money put into business by its owners
Along with other sources of finance it is used to buy assets
Assets = capital + liabilities
How do you calculate total assets?
Total assets = non current assets + current assets
How do you calculate total liabilities?
Total liabilities = current assets + non current assets
How do you calculate net assets ?
Net assets = total assets - total liabilities
How do you calculate total equity ?
Total equity = share capital + other money owing to shareholders
How statement of financial position presented?
Non current assets
Current assets
Current liabilities
Non current liabilities
Net assets
Shareholders equity
What are non current assets ?
long term resources used repeatedly by business over a long period of time eg. Land property and equipment (physical) and brand name, franchising agreements etc. (non physical )
What are current assets ?
Assets that will be changed into cash within a year
Inventories (stock of raw materials , components etc)
Trade and other receivables
Cash or cash equivalents
What are current liabilities ?
Money owed by business that must be repaid within one year eg. Loans and other borrowing like overdrafts and short term bank loans
What are non current liabilities?
Long term liabilities/loans —> doesn’t have to be repaid for at least a year eg. Loans, mortgages
What is meant by liquidity ?
Refers to the ease with which assets can be converted to cash. Non current assets eg. Property, machinery and tools are not liquid as it can’t be converted to cash quickly
What are current assets ?
They are liquid. Cash is totally liquid
Trade receivables: fairly liquid
Inventory: least liquid assets
Measuring liquidity:
1. Current ratio
Current ratio = current assets/current liabilities
If the current ratio is between 1:5:1 and 2:1 that means business has sufficient liquid resources
If it’s below 1:5 that means the business doesn’t have enough working capital due to overborrowing/over holding
If it’s above 2 it suggests that too much money is tied up unproductively eg. Keeping large amount of stock/inventory
Measuring liquidity:
Acid test ratio (most severe test of liquidity)
Acid test ratio = Current assets - inventories / current liabilities.
Inventories are least liquid asset they can take time to sell therefore they are excluded from current assets.
If it is less than 1:1 (safe ratio) it means its current assets - inventories does not cover its current liabilities indicating potential problems
However if a business is a retailer with strong cash flow may operate with acid test ratio more than one
How do you improve liquidity
Must raise current assets or reduce current liabilities (or both)
Sale of assets and leaseback
Supplier credit terms
Inventory (JIT)
How does sale of assets and leaseback improve liquidity?
Sell unwanted physical assets eg. Vehicles and leaseback when needed.
However, leasing can be expensive if it is long term
How does supplier credit terms improve liquidity?
Can save cash if it delays paying suppliers to reduce cash overflow.
However: suppliers may withdraw their credit facilities or refute to deliver goods in the future if delaying for too long
How does inventory by JIT improve liquidity
Reducing its inventories using JIT method meaning that stock of raw materials and components are delivered to business only when they’re needed —> will save storage costs
What is working capital ?
Needed to pay expenses eg. Wages, electricity needed to make a product
Relatively liquid asset : can easily be turned into cash ‘subtract’ - money owed by a business that needs to be payed in short term
Amount of working capital business has is an important issue, it can reflect how well a business is performing -> if a balance sheet shows a low level of working capital it could act as a signal the business is in trouble
How do you manage working capital ?
- Size of business : sales generate need for stock , trade credit and cash
Larger business = larger amount of working capital there’s likely to be - Inventory levels: more inventory needed = higher working capital. Businesses in different industries = different needs for inventory
- Debtors and creditors: time between buying inventory financed by trade credit and selling finished product
How do you maintain adequate levels of working capital: too little
Little levels of working capital = will encounter trading problems eg.
Not enough inventory of raw materials —> could find production stops when items run out
Not enough finished goods —> unable to fulfill orders online
Not enough cash in business —> might not be able to repay its bills on time
Borrowed too much trade credits -> owes too much to creditors-> might be unable to pay invoices when they’re due
