2.3.2 - Liquidity

Question 1

Define and explain Liquidity?

Answer 1

The ability of a business to turn its assets into cash to pay its current liabilities
• The ability of a business to turn its assets into cash
• The least liquid assets are listed at the top of the statement of financial position (balance sheet) – premises and specialist machinery for example may take a while to sell, while stock is easy to sell on
• Cash is the most liquid asset of all

Question 2

Define a Statement of financial position (balance sheet)?

Answer 2

• A PLC (Public Limited Company) or a LTD (Private Limited Company) business have to publish their accounts by UK law
• One of these accounts is the statement of financial position.

Question 3

Why do businesses measure liquidity?

Answer 3

• A business owner and their investors can use liquidity as a measure of how healthy the business is, this it doesn’t have too many debts and that it can easily pay its bills

Question 4

Name the two ways to measure liquidity?

Answer 4

• Current ratio

* Acid test ratio

Question 5

What’s the Current Ratio formula?

Answer 5

Current assets / Current liabilities

• The Ideal ratio is 1.5:1, lower than this and there is not enough money to pay bills.
• Higher than this and there is too much money tied up in stock.

Question 6

What’s the Acid Test Ratio formula?

Answer 6

Current Assets - Inventory / Current Liabilities

Question 7

Explain the Acid Test Ratio?

Answer 7

• This is also known as the quick ratio and is a harsher test of liquidity because you cannot guarantee to sell all of the stock. Stock can also spoil, become obsolete or just go out of fashion.
• If a business has an acid test ratio of less than 1:1 then its current assets (minus stocks) do not cover its current liabilities.
• This could mean a problem for the business.
• Again some retailers with strong cash flow and fast moving stocks may have an acid test of 0.4:1 and be fine, it depends on the industry.

Question 8

Name ways that liquidity can be improved?

Answer 8

• A business could reduce the amount of stocks that it holds, so finished goods need to be dispatched faster to customers.
• A business could reduce the credit period offered to customers, for example insist that customers pay in 30 days not 90.
• A business could also pay suppliers later on agreed credit terms.
• Increase borrowing long term and clear the short term debts.

Question 9

Define Working Capital?

Answer 9

Working capital means the day-to-day finance needed in a business and can be calculated by CA-CL.