2.3.2 Liquidity

Question 1

What is liquidity?

Answer 1

The ability of a business to meet its short term debts

Liquidity is crucial for maintaining operations and avoiding financial distress.

Question 2

What is the current ratio?

Answer 2

Current assets divided by current liabilities

A measure of a company’s ability to pay short-term obligations.

Question 3

What are current assets?

Answer 3

Assets that are expected to be converted into cash within one year

Examples include cash, accounts receivable, and inventory.

Question 4

What are current liabilities?

Answer 4

Obligations that a company needs to pay within one year

Examples include accounts payable and short-term debt.

Question 5

What is the acid test ratio?

Answer 5

Current assets minus inventory divided by current liabilities

This ratio provides a more stringent assessment of liquidity.

Question 6

List ways to improve liquidity

Answer 6

• Reduce credit period offered to customers
• Ask suppliers for an extended repayment period
• Make use of overdraft or short term loans
• Sell off excess stock
• Sell assets and lease fixed assets

These strategies help businesses manage cash flow more effectively.

Question 7

What is the ideal current ratio?

Answer 7

2:1

A ratio above 1 indicates more current assets than current liabilities.

Question 8

What is another acceptable current ratio range?

Answer 8

1-1.5:1

This indicates reasonable liquidity without excessive current assets.

Question 9

What is working capital?

Answer 9

Current assets minus current liabilities

It represents the funds available for day-to-day operations.

Question 10

How can a business increase working capital?

Answer 10

Introduce new capital and reduce drawings from the business

This helps ensure sufficient funds for operational needs.