2.3.2 Liquidity Flashcards
Liquidity:
Liquidity is the business’ ability to turn assets into cash to pay off current liabilities without changing market price. A balance sheet can assess business’ liquidity by looking at their assets and liabilities which determine their financial position.
Explaining assets and liabilities:
Current assets – assets business is able to turn into cash quickly. The most liquid asset that a business has is cash.
Current liabilities – short term debts/obligations business will need to pay in the short term e.g. bills.
Non-current assets – assets which cannot easily be turned into cash e.g. property.
Non-current liabilities – debts/obligations which the business have to pay in the long term e.g. longterm loans.
2 Ways to measure Liquidity:
1)Current ratio:
-current assets / current liabilities = x:1
2)Acid test ratio:
-(current assets - stock) / current liabilities = x:1
Meanings of Acid test ratio and Current Ratio
=if ratio x:1 is below 1= cash problems & x is 1.5-2.0= efficient working capital management.
= the higher current ratio figure = more able business is to pay off their current liabilities.
The acid test ratio is a more strict measure of liquidity as it does not make the assumption all stock/inventory os sold like current ratio = acid test ratio likely to be lower than current ratio.
Ways to improve liquidity:
if liquidity ratio below one, business could:
increase cash inflows by:
-increasing revenue by increasing price on products to bring in more cash however it depends on ped.
-reduce credit period- bring in liquid assets sooner
reducing cash outflows and shortages of cash:
-reduce budgeting on marketing- however this may decrease inflows as products arent advertised
-switch to a cheaper supplier- reduce spending on materials- however this decreases quality-less sales
-raise share capitals
-improve working capital management
What is working capital:
Working capital is the finance available for day to day run of business activities, this cash is required to cover daily costs daily; like equipment.
Calculating working capital:
Current assets - Current liabilities = x, if current assets are less than current liabilities - risk of failing & going bankrupt as business wont be able to pay short term debts.
How to manage working capital:
-minimise stock levels by destocking (holding less stock) to ensure sales are converted into cash without overstock eg by market research or using jit.
-increasing credit from suppliers to pay at later dates for stock however this can disrupt production schedules.
-minimising spending on assets, by leasing instead of buying equipment which spreads fixed cost in long term and saves working capital.
=the ability to manage working capital ensures operational efficiency as you have reduced conversion rate of working capital.
Importance of working capital:
-ensure business doesnt go into failure
-if working capital is short, vcs may increase like when buying in bulk
-cannot finance expenditures like rent or workers wage.
