2.3.2 Liquidity

Question 1

Definition of liquidity

Answer 1

The ability of a business to turn its assets into cash to pay its current liabilities

Question 2

What are the two ways to measure liquidity?

Answer 2

1. Current ratio

2. Acid test ratio

Question 3

Definition of current ratio

Answer 3

Assesses whether or not a business has enough resources to meet any debts that arise in the next year.

Question 4

Definition of acid test ratio

Answer 4

A more severe test of liquidity and excludes stocks from current assets

Question 5

How do you calculate current ratio?

Answer 5

Current assets / current liabilities

Question 6

How do you calculate acid test ratio?

Answer 6

Current assets - Inventory / Current liabilities

Question 7

Acid test conclusions

Answer 7

• cannot guarantee that stock will be sold

- if business has a ratio of less than 1:1 them it’s current assets do not cover its current liabilities

Question 8

Ways that liquidity can be improved

Answer 8

1. business could reduce the amount of stock holds, so finished goods need to be dispatched faster.
2. reduce the credit period offered to customers
3. pay suppliers at a later date on agreed terms
4. increase borrowing long term and clear the short term debts
5. Encourage cash sales and sell off stock - offer discounts
6. Reduce personal drawings from the business
7. Introduce fresh capital, sell shares

Question 9

What is working capital?

Answer 9

• the day to day finance needed in a business and can be calculated by CA - CL