2.3.2 liquidity

Question 1

what is liquidity

Answer 1

a business’s ability to turn its assets into cash to meet its short-term liabilities

Question 2

what is a statement of financial position (balance sheet)

Answer 2

• a snapshot of a firms finances at a fixed point in time
• it shows a firms assets, liabilities and capital

Question 3

assets can be both current and non-current, whats the difference

Answer 3

• 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)

Question 4

what is the difference between current and non-current liabilities

Answer 4

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)

Question 5

what is net assets

Answer 5

assets - liabilities

Question 6

what is capital employed

Answer 6

the total funding a business has acquired (could be from retained profit, share capital etc.)

Question 7

net assets and capital employed should always balance

Answer 7

-

Question 8

what are the two measures of liquidity we need to know

Answer 8

1 current ratio
2 acid test ratio

Question 9

how do you calculate the current ratio

Answer 9

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

Question 10

evaluate the use of the current ratio

Answer 10

+ 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

Question 11

how do you calculate acid test ratio

Answer 11

(current assets - inventory) / current liabilities

• ideally should be higher than 1

Question 12

discuss the acid test ratio

Answer 12

+ 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

Question 13

define working capital

Answer 13

the amount of cash that a business has to pay its day-to-day debts

Question 14

the more working capital the more _______ a business is. working capital is the same as ___ ________ _____ .

Answer 14

liquid, net current assets

Question 15

what is the working capital cycle

Answer 15

• this is the time between buying raw materials and getting cash from the sale of the finished product

Question 16

what is the length of the working capital cycle dependent on

Answer 16

• 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

Question 17

how much cash does a business really need

Answer 17

• 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

Question 18

what factors affect how much cash a business needs

Answer 18

• 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

Question 19

what are the ways to improve liquidity

Answer 19

• 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