2.3.2 Liquidity

Question 1

Statement of financial position (balance sheet)

Answer 1

• The statement of financial position contains the financial information required to draw conclusions about the liquidity of the business
• Liquidity is the ability of a business to meet at short term commitments with its available assets
• The statement of financial position shows the financial structure of a business at a specific point in time. It identifies a businesses assets and liabilities and specifies the capital used to fund the business.

Question 2

Current and non-current assets, current and non-current liabilities

Answer 2

• Non-current assets: items that are owned by business for the long-term. Examples include machinery and buildings.
• Current assets: items that converted to cash quickly – usually within 12 months. Current assets of comprised of cash, trade receivables and inventory.
• Current liabilities: money of business owes and is due to be settled soon – usually within 12 months. Current liabilities includes a trade payable and short-term borrowing such as a bank overdraft.
• Non-current liabilities: money of business owes and that does not need to be paid back for at least 12 months. No current liabilities include bank loans and mortgages.

Question 3

The current ratio

Answer 3

• The current ratio is a quick way to measure equity and the outcome is expressed as a ratio
• The result indicates how many pounds of current assets it has available to cover each £1 of short-term debt

Current assets/current liabilities

Question 4

The acid test ratio

Answer 4

• More precise way to measure equity and is expressed as a ratio
• The least liquid form of current assets (inventory/stock) is deducted to the acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly

Current assets – inventory/current liabilities

Question 5

Ways to improve liquidity

Answer 5

• The best way to improve your qualities to manage the business better: use cash flow forecast to identify potential cash flow issues before they arise and take appropriate action, budget effectively and consider adopting zero budgeting to carefully control spending, set clear financial objectives and look for ways to reduce costs and increase income wherever possible

1. Reduce the credit period offered to customers.
   - Collecting money owed from customers more quickly will increase the level of current assets in the business. Customers may move to competing businesses that offer better credit terms
2. Our supplies for an extended repayment period.
   - Current liabilities will not be reduced in the business can use cash it would’ve paid to supplies for other purposes however supplies may be unwilling to extend credit terms
3. Make use of overdraft facilities or short-term loans.
   - Current liabilities will increase in the business could spend more money than it has in its bank account however banks may be reluctant to lend a businesses with cash flow problems
4. Sell off excess stock.
   - Less liquid current assets will be reduced and converted into more liquid forms of current asset like cash. Storage and security cost may also be reduced however stop they need to be sold at a low price to attract sales.
5. Sell assets and lease fixed assets instead.
   - Both current assets and current liabilities will increase and the business will continue to have the use of assets but must make regular payments to the leasing company
6. Introduced new capital and reduced drawings from the business.
   - New capital will be introduced by the owner or from additional investors. It may result in the dilution of control of the business

Question 6

Managing working capital

Answer 6

• Working capital is the money that business has to fund its day-to-day activities
• It’s often described as net current assets on the statement of financial position

Current assets – current liabilities

Question 7

Managing working capital

Answer 7

If a business doesn’t have enough working capital it can:
- Look to convert current assets into cash as quickly as possible (e.g. by selling the stock at lower prices or by more purposefully trading payment from customers)
- Request an extension of payment terms from suppliers
- Make use of short-term borrowing options such as overdraft

If a business has too much working capital it can:
- It’s likely to be missing out on the benefits of investing in fixed assets or investment
- May represent a significant opportunity cost especially when interest rates are high
- If a business is holding large amounts of inventory at main car extra storage cost and could use the cash tied up in the stock for other purposes