2.3.2 Liquidity

Question 1

Liquidity

Answer 1

Liquidity is the ability of a
business to find the cash
it needs to pay its bills.
The cash must be readily
available either in the bank
account or in the form of a
payment from a customer
that is due very soon.

Question 2

Current assets

Answer 2

Current assets are items
the business owns that are
in the form of cash or can
be easily turned into cash
quickly without a major loss
in their value. There are
three current assets: cash,
money owed by customers
(receivables/debtors and
stock.

Question 3

Current liabilities

Answer 3

Current liabilities are debts
owed by the business that
are due to be paid within
the next 12 months. The
two main current liabilities
are trade creditors and
overdrafts.

Question 4

Current ratio

Answer 4

Current assets/ current liabilities

Question 5

What does current ratio show

Answer 5

This therefore means that if a company has a current ratio of 1.5:1, it will
overdrafts.
have £1.50 of current assets for each £1 of short-term debt it has. If the
ratio is significantly lower than 1.5:1, this could mean that it will face
problems settling its short-term debts. If the ratio is significantly higher
than 1.5:1, the business could be criticised for having too much of its
resources tied up in non-productive current assets.

Question 6

Calculating acid test ratio

Answer 6

(Total current assets- inventories)/ current liabilities

Question 7

Improving liquidity

Answer 7

Improving liquidity relies upon bringing extra cash onto the balance
sheet. This could involve one or more of the following:
• Selling under-used fixed assets such as equipment or machinery
• Raising more share capital
• Increasing long-term borrowing through loans
• Postponing planned investments

Question 8

Fixed assets

Answer 8

Fixed assets are items
owned by the business
which it intends to use over
and over to generate profit.
Examples include property
and machinery.

Question 9

Working capital

Answer 9

Working capital is the
money that is available for
the day-to-day running of
the business.

Question 10

Working capital cycle

Answer 10

Capital injected into the business -> sell to customers on credit -> customers (debtors) pay up -> buy materials -> produce goods

Question 11

Managing
this cycle, to ensure that there is always enough working capital in the
system to prevent blockages or delays, is crucial to successful financial
management. Actively managing the working capital cycle involves:

Answer 11

• ensuring there is enough money in the system altogether

* making sure cash moves through the cycle as quickly as possible.

Question 12

If these two requirements are to be met financial managers are likely to
consider the following actions:

Answer 12

Control cash used. This involves keeping the amount of cash used as
low as possible, by reducing stock levels, controlling credit periods offered to customers and gaining as much credit as possible from
suppliers, and getting products on sale as quickly as possible.
Minimise spending on fixed assets. This can be helped by leasing
rather than buying new assets, which prevents large outflows of cash
draining working capital from the system.
Plan ahead to estimate carefully the amount of cash that will be needed
in the next few months. This will ensure that adjustments to the cycle
can be made in good time.