2.3.2 Liquidity Flashcards
liquidity
the ability of a business to meet its short term commitments with its available assets
why is managing liquidity important?
a business that cannot pay its bills will usually fail very quickly, even if they are profitable
-managing liquidity is a key way to manage risk in a business- helps a business prepare for the unexpected
what does the Statement of Financial Position contain?
the financial information required to draw conclusions about the liquidity of the business
-it shows it at a specific point in time
-identifies its assets and liabilities, specifying the capital used to fund the business
whats another name for the Statement of Financial Position?
the Balance Sheet
non-current assets and examples
items that are owned by a business for the long-term
e.g. machinery and buildings
current assets and examples
items that are converted to cash quickly, usually within 12 months
e.g. cash, trade receivables and inventory
current liabilities and examples
money a business owes and is due to be settled soon- within 12 months
e.g. trade payables, short term borrowing like a bank overdraft.
non-current liabilities and examples
money a business owes and that does not need to be paid back for at least 12 months
e.g. bank loans and mortgages
net assets equation
assets - liabilities
another word for net assets
capital employed
cash flow statement
this shows how the business has generated and disposed of cash and liquid funds during the period under review.
net current assets/ working capital equation
current assets- current liabilities
net capital employed equation
non-current liabilities + total share holder’s equity
what does liquidity assess?
whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due
give two ways to measure liquidity
the current ratio and the acid test ratio
the current ratio
-an effective measure for businesses that hold little stock
-quick way to measure liquidity and expressed as a ratio
current ratio formula
current assets/ current liabilities
= ?:1
the acid test ratio
-a precise way to measure it, expressed as a ratio
-important for businesses that hold a large amount of stock
acid test ratio formula
(current assets - inventory) / current liabilities
= ? : 1
why is cash flow management crucial?
to avoid cash flow problems, for example from customers paying late, having to pay suppliers early with not enough money to do so.
how to improve liquidity?
-use cash flow forecasts to identify problems before they arise
-budget effectively and consider adopting zero budgeting to control spending
-set clear financial objectives and look to reduce costs and increase incomes where possible
how can reducing credit period offered to customers improve liquidity?
-collecting money owed from customers faster increases the level of current assets
-customers may move to competing businesses that offer better credit terms however
how can asking suppliers for an extended repayment period improve liquidity?
current liabilities will not be reduced
-business can use cash for other purposes
-suppliers may be unwilling to extend credit terms
how can using overdrafts or short term loans improve liquidity?
-current liabilities increase
-business can spend more money than it has available in account
-banks may not give money if they are having cash flow problems
how can selling off excess stock improve liquidity?
-less liquid current assets will be reduced and converted into more liquid forms of current asset
-storage and security costs reduced
-stock may need to be sold at a lower price however to attract fast sales
how can selling assets and leasing fixed assets instead improve liquidity?
-both current assets and liabilities will increase
-the business will use assets but make regular payments to the leasing company
describe some common cash flow problems
low profits
-cause of business failure, cannot pay bills- most important source of finance
too much production capacity
-spending too much on fixed assets
excess inventory held
-ties up cash, but
-needs to be enough stock to meet demand and can be cheaper to bulk buy
offering too much credit to customers
-its a good way to build sales, however late payment is problematic
seasonal demand
-predictable changes in demand and cash flow
-can be managed, but need to allow for seasonal changes
overtrading
-expanding too fast puts pressure on short term finance
working capital
the money that a business has to fund its day to day activities
(net current assets)
working capital formula
current assets - current liabilities
why is cash the most liquid of a business’s current assets?
it is immediately available for transactions, and can be used to settle debts immediately
how can working capital be managed
involves careful cash management
-having less liquid debtors and inventory
-convert current assets into cash as soon as possible
-requesting extension of payment terms from suppliers
-making use of short term borrowing options e.g. overdrafts, allows businesses to access more cash than it has in its current account
problems with a business having too much working capital
-if a business holds too much cash, it may be missing out on benefits of investing in fixed assets or investments
-may represent an opportunity cost, if interest rates are high
-holding too much inventory can incur extra storage costs
