2.3.2 Liquidity Flashcards
Definition: Liquidity
• The ability of a business to turn its assets into cash to pay its current liabilities
Definiton: Statement of financial position (balance sheet)
• 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. In older text books and on the Internet you may also see it called the balance sheet
Measuring liquidity
• 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
• The tools to measure liquidity (ability to pay bills) is the statement of financial position and two key ratios
• Current ratio
• Acid test ratio
Current ratio formula
Current assets / Current liabilities
Acid test ratio formula?
(Current assets -inventory ) / Currant liabilities
Acid test conclusions
A. 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.
B. 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.
C. This could mean a problem for the business
D. 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
Ways that liquidity can be improved
• 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
Definition: Working capital
• Working capital means the day-to-day finance needed in a business and can be calculated by CA-CL
Advantages and disadvantages of working capital?
Advantages
1. Improved Liquidity: Working capital helps businesses maintain sufficient cash flow to cover short-term obligations such as payment of salaries, rent, utilities, and suppliers.
2. Flexibility: With adequate working capital, businesses can take advantage of unexpected opportunities, such as discounts on bulk purchases, and invest in new growth opportunities.
3. Improved Credit Rating: Businesses with sufficient working capital are perceived as less risky by lenders and investors.
Disadvantages
1. Increased Interest Costs: Maintaining excess working capital can lead to increased borrowing costs, as businesses may have to borrow more money than they need to meet their short-term obligations.
2. Opportunity Costs: Holding too much working capital can also result in missed investment opportunities that could generate higher returns for the business. This can limit the business’s potential for growth and profitability.
3.Reduced Efficiency: Holding too much inventory or accounts receivable to maintain high levels of working capital can lead to reduced efficiency in business operations. Excess inventory, for example, can result in increased storage and handling costs, while accounts receivable that remain unpaid for too long can impact cash flow and increase the risk of bad debt.
What happens if you have too much working capital?
