2.3.2 liquidity Flashcards
what is liquidity
a business’s ability to turn its assets into cash to meet its short-term liabilities
what is a statement of financial position (balance sheet)
- a snapshot of a firms finances at a fixed point in time
- it shows a firms assets, liabilities and capital
assets can be both current and non-current, whats the difference
- current assets are assets that can be quickly turned into cash (usually in 12 months) like receivables and inventory
- non-current assets are assets that a business intends to keep for a long time (like property or machinery)
what is the difference between current and non-current liabilities
current = money a business owes and is due to be settled soon (overdraft, taxes)
non-current = money a business owes but doesn’t have to be paid for another 12 months (mortgages, loans)
what is net assets
assets - liabilities
what is capital employed
the total funding a business has acquired (could be from retained profit, share capital etc.)
net assets and capital employed should always balance
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what are the two measures of liquidity we need to know
1 current ratio
2 acid test ratio
how do you calculate the current ratio
current ratio = current assets / current liabilities
- a figure less than 1 means that the business is unable to cover their liabilities
- ideal figure would be between 1.5 and 2
- a figure higher than 2 might mean there is too much money tied up in assets that could be invested into the business
evaluate the use of the current ratio
+ quick way to measure liquidity
+ good for busineses that don’t hold lots of inventory
- not good for businesses that hold lots of inventory as then the stock wouldn’t be very liquid as there is so much of it
how do you calculate acid test ratio
(current assets - inventory) / current liabilities
- ideally should be higher than 1
discuss the acid test ratio
+ more tougher accurate test of liquidity
NOTE: a firm with a high stock turnover, like a supermarket may have a low acid ration and still survive
define working capital
the amount of cash that a business has to pay its day-to-day debts
the more working capital the more _______ a business is. working capital is the same as ___ ________ _____ .
liquid, net current assets
what is the working capital cycle
- this is the time between buying raw materials and getting cash from the sale of the finished product
what is the length of the working capital cycle dependent on
- how long the stock is held for
- how long it takes to make the product
- how long the credit period is for the suppliers
- the length of the credit period given to the customers
how much cash does a business really need
- a business needs just enough cash
- too little and the business may fail
- too much and the business is static and they should be investing the cash into the business
what factors affect how much cash a business needs
- length of the working capital cycle, longer cycles need more cash as they have to wait longer for money from the sale
- if inflation is high businesses’ need more cash
what are the ways to improve liquidity
- cash flow forecasts, this helps manage and predict cash flow problems before they happen
- zero-based budgeting allows for careful control of spending
- reduce credit period offered to customers
- ask suppliers to extend the credit period
- make use of an overdraft
