20.4 Liquidity

Question 1

What is liquidity?

Answer 1

It is the ability of the business to repay its current liabilities when they fall due.

Question 2

What does liquidity measure?

Answer 2

It measures the ability of a business to convert its current assets into cash to pay for its current liabilities. The more cash and liquid assets a business owns compared to its current liabilities, the higher its liquidity.

Question 3

Define ‘liquid’ in accounting.

Answer 3

‘Liquid’ in accounting means how quickly the assets of a business can be converted into cash to pay its current liabilities.

Question 4

Why is it important for a business to be liquid?

Answer 4

Because cash is required to run its daily operations, such as buying inventory, paying for rent, salaries, utilities, etc.

Question 5

What happens when a business does not have cash to pay its credit suppliers when the debt is due?

Answer 5

The credit suppliers will be unwilling to continue to sell goods or services on credit to the business. As the business does not have sufficient cash to buy goods or services on cash terms, the business may not be able to offer its customers any goods or services.

Question 6

What happens when rent is not paid?

Answer 6

The business may not be able to continue to occupy the premises.

Question 7

What happens when staff members are not paid their salaries?

Answer 7

They are likely to terminate their employment services.

Question 8

What may a bank be unwilling to do when a business is low in its liquidity?

Answer 8

Banks may not be willing to provide short term loans for fear that the business is unable to repay the loans.

Question 9

What happens when a business does not have the cash to run its daily business operations for a prolonged period of time?

Answer 9

It cannot continue operating and may be forced to close down even when it is profitable.

Question 10

What is the difference between profitability and liquidity?

Answer 10

Profitability measures the ability of a business to earn enough profit while liquidity measures the ability to repay current debts.

Question 11

Can a profitable business be liquid?

Answer 11

Not necessarily.

1. The business could have spent its cash to buy non-current assets, which are not easily converted to cash. As a result, the business may have very little cash or liquid assets left.
2. A business which sells on credit may have high sales revenue and profit, but low amount of cash.

Question 12

Does a low profit mean that the business has a low amount of cash or liquid assets?

Answer 12

Not necessarily. For instance, depreciation reduces profit but has no impact on the amount of cash a business has.

Question 13

What should a healthy business do?

Answer 13

Strike a balance between profitability and liquidity.

Question 14

How can absolute liquidity values be analysed?

Answer 14

Through Working Capital.

Question 15

What does working capital refer to?

Answer 15

Working capital refers to the excess of current assets over current liabilities. It is obtained by deducting total current liabilities from total current assets. (Refer to chapter 10 flashcards on working capital.)

Question 16

List the two financial ratios used to measure liquidity.

Answer 16

1. Working capital ratio or current ratio

2. Quick ratio or acid test ratio

Question 17

What does working capital ratio or current ratio measure?

Answer 17

The ability of a business to pay its short-term debts using its current assets.

Question 18

What does the working capital ratio or current ratio compare?

Answer 18

The amount of total current assets to total current liabilities.

Question 19

What does a working capital ratio of 1:1 mean?

Answer 19

It means that total current assets equals total current liabilities.

Question 20

What does a working capital ratio of 1.5:1 mean?

Answer 20

It means that total current assets is 1.5 times as much as total current liabilities.

Question 21

What is the formula for Working Capital Ratio (Current Ratio)?

Answer 21

Total Current Assets / Total Current Liabilities

Question 22

What does it mean when a business has a higher working capital ratio?

Answer 22

It means the more ready the business is in paying off its current liabilities.

Question 23

What is the acceptable norm for working capital ratio?

Answer 23

2:1. At a ratio of 2:1, the business has twice as much current assets ready to meet its current liabilities. This is considered safe.

Question 24

Is it true that the higher the working capital ratio, the better it is?

Answer 24

No. Too high a liquidity ratio could mean holding too much idle cash on hand when this cash could be put to more profitable use. Having excess cash in the bank which attracts a low interest rate is also not a good form of cash management.

Question 25

What are the disadvantages of having too high a working capital ratio?

Answer 25

1. Too high a liquidity ratio could mean holding too much idle cash on hand when this cash could be put to more profitable use.
2. Having excess cash in the bank which attracts a low interest rate is also not a good form of cash management.

Question 26

Is it okay to compare the working capital of two businesses that are of different sizes?

Answer 26

No, it is not meaningful and also misleading to compare the working capital of two businesses that are of different sizes.

Question 27

Does the nature of the business determine the amount of working capital needed?

Answer 27

Yes. For instance, the construction company usually has to pay for the materials and workers’ salaries first, so as to construct the building before it collects the full payment from its client when the building is completed. On the other hand, as goods are sold in the supermarket, cash is collected. The cash can be used to pay for purchases of goods. Between these two types of businesses, the construction company needs a higher working capital than the supermarket. Hence, it is only meaningful to compare working capital between businesses in the same trade.

Question 28

Does a higher working capital in a business mean that the business is more liquid than another business with a lower working capital?

Answer 28

No. It is fairer to evaluate the liquidity of a business based on liquidity ratios.

Question 29

Which does quick ratio (or acid test ratio) measure?

Answer 29

It measures the ability of a business to pay its short-term debts using quick assets.

Question 30

What are quick assets?

Answer 30

Cash and other current assets that can be converted into cash quickly. Quick assets are considered more liquid than current assets.

Question 31

Why is the quick ratio / acid test ratio considered to be a stricter measurement of liquidity than working capital ratio?

Answer 31

Because quick assets are considered more liquid than current assets.

Question 32

What do quick assets comprise of?

Answer 32

Cash and net trade receivables.

Question 33

Are inventory and prepayments considered quick assets?

Answer 33

No. It is more difficult to convert inventory into cash as it has to be sold or returned to the suppliers first before cash is collected. Similarly, prepayments will almost never be converted into cash on an urgent basis.

Question 34

What is the formula for quick ratio / acid test ratio?

Answer 34

Quick assets / Total current liabilities
where Quick Assets = Cash in hand + Cash at Bank + Net Trade Receivables
Or
Quick Assets = Total current assets - Inventory - Prepayments

Question 35

What does a higher quick ratio mean?

Answer 35

The more ready a business is in meeting its current debts when they are due. In general, a quick ratio greater than 1;1 is preferred.

Question 36

What does a quick ratio of less than 1, e.g 0.8:1 or 0.6:1 mean?

Answer 36

It means that it is a concern for the business as it is not able to pay all its current debts when they are due.

Question 37

Which is a stricter indicator of liquidity? Working capital ratio or quick ratio?

Answer 37

Quick ratio. A business may have a working capital ratio of 2:1 but it is considered to have poor liquidity if its quick ratio is 0.8:1. Stakeholders should use the quick ratio when it is important to be stricter in assessing the ability of the business to repay its current debts.

Question 38

When should the working capital ratio be used?

Answer 38

When stakeholders are less concerned with the ability of the business to repay current debts.

Question 39

How can liquidity be improved?

Answer 39

By either:
1. increasing current assets, or
2. decreasing current liabilities.
Any measure to increase cash will increase liquidity.

Question 40

Give some examples of how a business can increase its cash.

Answer 40

1. request from owners or shareholders to contribute additional capital in the form of cash.
2. Take up a long-term loan.
3. Generate more sales revenue so as to generate more cash.
4. Hold just sufficient inventor for resale. In this way, cash is not used up in buying inventory.
5. Reduce outflow of cash by negotiating for longer repayment period from its suppliers.
6. Sell excess or non-essential non-current assets, e.g. funds can be raised by selling an office building and renting it from the new owners.