2.3.2 Liquidity Ratios

Question 1

Current assets

Answer 1

Items that are owned by an organisation for a period of less than 1 year.

Question 2

Non-current assets

Answer 2

Items that are owned by an organisation for a period of over 1 year.

Question 3

Current liabilities

Answer 3

Items that are owed by an organisation for a period of less than 1 year.

Question 4

Non-current liabilities

Answer 4

Items that are owed by an organisation for a period of over 1 year.

Question 5

Total equity

Answer 5

Difference between assets and liabilities.

Question 6

Statement of financial position

Answer 6

A financial document that shows the value of all a businesses assets and liabilities, and how the business has funded the purchase of assets.

Question 7

Net Current Assets

Answer 7

Current assets – Current liabilities

Question 8

Net assets

Answer 8

Net current assets + non-current assets – non-current liabilities

Question 9

Capital employed

Answer 9

Net assets. The total funding.

Question 10

Liquidity ratios

Answer 10

Shows whether a firm is able to meet its short term liabilities and meet its debts.

Question 11

Current ratio

Answer 11

Shows businesses ability to meet debts over the next year.

Question 12

Current ratio formula

Answer 12

Current assets/Current liabilities

Question 13

Ideal value of current ratio

Answer 13

Ideal value between 1.5 and 2. Expressed as a ratio (x:1)

Question 14

Acid test

Answer 14

Measures very short liquidity.

Question 15

Acid test formula

Answer 15

Current assets-stock/Current liabilities

Question 16

Ideal value of acid test

Answer 16

More accurate indicator as it takes out stock which is considered to be less liquid than cash.
Ideal value is between 0.75 and 1.

Question 17

Ways to improve liquidity

Answer 17

• Raising more cash.
• Selling under-used fixed assets
• Agreeing long-term borrowing.
• Reducing short-term borrowing.
• Raising more share capital.
• Postponing planned investments.

Question 18

Working capital

Answer 18

The day-to-day finance used in the business.

Question 19

Working capital formula

Answer 19

Current assets – Current liabilities
A measure of liquidity: The ability to convert an asset into any form (usually cash) without any delay.

Question 20

Working capital cycle

Answer 20

Produce goods  Sell to customers on trade credit  Customers pay up  Buy materials (Capital injected into the business)

Question 21

Reasons why working capital is important to a business

Answer 21

• Small businesses: large firms delay payments, limited access to funds.
• Expanding business: Increasing expenditure will impact on working capital.
• Enables business to survive day to day.
• Businesses with long working capital cycles incur unpredictable costs.

Question 22

Problems with having too much working capital

Answer 22

• If a business is holding large amounts of cash it is likely to be missing out on investing it: 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 and handling costs) and could use the cash ‘tied up’ in this stock for other purposes.

Question 23

Ways to improve working capital

Answer 23

• Reduce trade credit.
• Negotiate extra credit.
• Cut production costs.
• Negotiate additional short term loans or overdrafts.
• Careful financial planning.
• Effective stock management.
• Sale and leaseback redundant assets.