2.3.2 Liquidity Flashcards
Define ‘liquidity’ in a business.
- The ability of a business to meet its short term commitments (e.g. payments to creditors) with its available assets
A business that cannot pay its bills will usually fail very quickly, even if they are profitable
Managing liquidity is key way to manage risk in a business -& helps a business to prepare for the unexpected
What does the statement of financial position (Balance sheet) show?
- Shows the financial structure of a business at a specific point in time
- Identifies a businesses assets & liabilities & specifies the capital (money) used to fund the business
Also known as the Balance Sheet
What are the two ways used to measure liquidity?
Using two ratios:
- The current ratio
- The acid test ratio
What is the current ratio?
- A quick way to measure liquidity & the outcome is expressed as a ratio
- All forms of current asset are considered in this ratio
The current ratio is an effective liquidity measure for businesses that hold little stock
The result indicates how many £s of current assets it has available to cover each £1 of short term debt
What is the formula used to work out current ratios?
Current assets/ Current Liabilities
= ?:1
What is the acid test ratio?
A precise way to measure liquidity & is expressed as a ratio
The acid test ratio is also known as the liquid capital ratio
The least liquid form of current assets (inventory/stock) is deducted so the acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly
It is a particularly important measure of liquidity for businesses that hold a large amount of stock
What is the formula used to work out the acid test ratio?
Current assets - Inventory/ Current Liabilities
= ?:1
What ways are there to improve liquidity?
- Manage the business better- Use cashflow forecasts to identify potential cash flow issues before they arrive & take appropriate action
- Budget effectively & consider adopting zero budgeting to carefully control spending
- Reduce the credit period offered to customers - Collecting money owed from customers more quickly will increase the level of current assets in the business- HWVR Customers may move to competing businesses that offer better credit terms
-
Sell off excess stock- Less liquid current assets will be reduced & converted into more liquid forms of current asset (e.g. cash)
Storage & security costs may also be reduced
HWVR Stock may need to be sold at a low price to attract sales -
Sell assets & lease fixed assets instead- Both current assets & current liabilities will increase
The business will continue to have the use of assets but must make regular payments to the leasing company
Define ‘working capital’
- Working capital is the money that a business has to fund its day to day activities
Often described as net current assets on Statement of Financial Position
What is the formula used to calculate working capital?
- Current Assets - Current Liabilities
What is the most liquid item within a business?
- Cash is most liquid of a business’s current assets & can be used to settle debts immediately
How does effective management of working capital work?
- Effective management of WC involves careful cash management
- Debtors and inventory (e.g. stock) are less liquid
- Businesses that are struggling with a lack of working capital may look to convert these current assets into cash as quickly as possible (e.g. by selling the stock at lower prices or by more purposefully chasing payment from customers)
- Requesting an extension of payment terms from suppliers can increase working capital in the short term as cash remains in the business for longer
- Making use of short-term borrowing options such as overdrafts can improve a businesses working capital situation as it can access more cash than it has in its current account
How can a business have too much working capital?
- If a business is holding large amounts of cash it is likely to be missing out on benefits of investing it in fixed assets or investments
This may represent a significant opportunity cost especially when interest rates are high
If a business is holding large amounts of inventory it may incur extra storage costs (e.g. security & handling costs) & could use the cash ‘tied up’ in this stock for other purposes
What is a common error made with cash & liquidity?
common exam error is confusion between working capital & cash. Whilst working capital includes cash, it also includes less liquid current assets (e.g. trade receivables & inventory). These less liquid assets cannot be used to pay bills & so, whilst a business may have a positive working capital figure, it may still fail because it cannot meet its immediate financial commitments.
