Chapter 35- Liquidity

Question 1

Statement of Financial Position (balance sheet)

Answer 1

Provides a summary of assets, liabilities and capital.

-Produced at the end of the financial year – can also be called a balance sheet

Question 2

Assets

Answer 2

The resources owned by the business
•Non-Current

= Capital + liabilities

Question 3

Liabilities

Answer 3

The debts of the business, e.g. overdraft, mortgage

Question 4

Capital

Answer 4

Money put into the business by owners

Question 5

Non-current assets

Answer 5

long-term resources that will be used repeatedly by the business over a period of time – they may be called fixed assts – common examples include land, property, plant equipment, tools, vehicles

Question 6

Current assets

Answer 6

Assets that will be changed into cash within 12 months – they are liquid assets – the liquidity of an asset is how easily it can be converted into cash – common examples include inventories and trade.

Question 7

Current liabilities

Answer 7

Any money owed by a business that must be repaid within one year e.g. loans

Question 8

Non-current liabilities

Answer 8

Relate to long-term loans and any other money owed by the business that does not have to be repaid for at least one year. E.g. long term bank mortgages

Question 9

Net assets

Answer 9

Calculated by subtracting the value of total liabilities from total assets

Question 10

Shareholders’ equity

Answer 10

The final section of the balance sheet is the shareholder’s equity – this provides a summary is owed to the owners of the business

Question 11

Measuring liquidity

Answer 11

Current ratio

Acid test ratio

Question 12

Current ratio

Answer 12

Is the liquidity ratio and focuses on the current assets and current liabilities of a business – it can be calculated using the formula

= current assets/ current liabilities

Question 13

Acid test ratio

Answer 13

More severe test of liquidity – this is because inventories are not treated as a liquid recourse – there is no guarantee that stocks can be sold and they may become obsolete or deteriorate – they are therefore excluded from current assets when calculating the ratio

= current assets – inventories/ current liabilities

Question 14

Working capital

Answer 14

Amount of money needed to pay the day-to-day trading of a business – A business needs working capital to pay expenses such as wages, electricity and gas charges, and to buy components to make products

= Current assets – Current liabilities

Question 15

Liquidity

Answer 15

A business’s liquidity is its ability to honour its short-term financial commitments.

• Cash is vital – without cash managers may not be able pay suppliers, wages, tax or repay loans
• Liquidity can be measured using the current ratio or the acid test ratio

Question 16

3 ways of coping with liquidity issues

Answer 16

1. Increasing cash inflows
2. Decreasing cash outflows
3. Source external finance

Question 17

3 ways of increasing inflows

Answer 17

1. Advertising and Promotion
2. Adjusting pricing strategies
3. Reducing trade credit period

Question 18

Advertising and Promotion

Answer 18

Investing in effective advertising and promotions should increase the awareness of the business and drive greater sales. This will increase inflows as long as customers are not offered trade credit for their purchases.

However. Increasing advertising campaigns increases the costs of the business meaning more cash exiting the business. Managers must be confident that such moves will drive greater sales to prevent a worse liquidity situation.

Question 19

Adjusting pricing strategy

Answer 19

Greater prices means more cash generated per sale, whilst reducing the prices means although less revenue is made per sale, more revenue is generated overall.

However. If managers are not accurate in their assessment of price elasticity of the goods and services they sell, they could make price changes that damages revenue.

Question 20

Reducing trade credit period

Answer 20

By reducing the period of time customers are offered trade credit. Cash can enter the organisation at a faster rate alleviating cash shortage during critical months.

However. If trade credit is a key part of the organisations selling point it could damage brand reputation.

Question 21

2 ways of Decreasing cash outflows

Answer 21

1. Trim marketing costs

2. Reduce stock and materials

Question 22

Trim marketing costs

Answer 22

For example, the amount spent on advertising and promotions. This is often a costly part of expenditure so could rapidly decrease costs.

However. It may have damaging impacts on the cash entering the business if advertising or promotions such as sponsorships are key catalysts for sales.

Question 23

Reduce stock and materials

Answer 23

This could be achieved by sourcing stock from alternative suppliers at a lower price.

However. May risk lowering levels of quality in production which could damage sales and brand identity.

Question 24

How should managers solve a liquidity crisis?

Answer 24

Cash flow forecasts are a prediction of what might happen, they are not necessarily accurate. Managers need to be careful when making radical changes to the business based on forecasts that could be inaccurate. This is most important for entrepreneurs who perhaps have little past information to base their decisions on.

If cash shortages are likely to last for only a short period of time than overdrafts are a less risky solution. However, the business may not be eligible for a large overdraft or may be refused by a bank.

A firm that prides itself on quality would be hesitant to reduce expenditure. Focusing on inflows would be a more viable solution.

Undifferentiated product producing companies may focus on reducing outflows such as costs in the hope of increasing inflows.

Adjusting trade credit may also be a viable option but only for those who offer trade credit or rely on large amounts of stock to produce their product.