Chapter 35- Liquidity Flashcards
Statement of Financial Position (balance sheet)
Provides a summary of assets, liabilities and capital.
-Produced at the end of the financial year – can also be called a balance sheet
Assets
The resources owned by the business
•Non-Current
= Capital + liabilities
Liabilities
The debts of the business, e.g. overdraft, mortgage
Capital
Money put into the business by owners
Non-current assets
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
Current assets
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.
Current liabilities
Any money owed by a business that must be repaid within one year e.g. loans
Non-current liabilities
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
Net assets
Calculated by subtracting the value of total liabilities from total assets
Shareholders’ equity
The final section of the balance sheet is the shareholder’s equity – this provides a summary is owed to the owners of the business
Measuring liquidity
Current ratio
Acid test ratio
Current ratio
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
Acid test ratio
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
Working capital
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
Liquidity
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
3 ways of coping with liquidity issues
- Increasing cash inflows
- Decreasing cash outflows
- Source external finance
3 ways of increasing inflows
- Advertising and Promotion
- Adjusting pricing strategies
- Reducing trade credit period
Advertising and Promotion
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.
Adjusting pricing strategy
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.
Reducing trade credit period
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.
2 ways of Decreasing cash outflows
- Trim marketing costs
2. Reduce stock and materials
Trim marketing costs
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.
Reduce stock and materials
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.
How should managers solve a liquidity crisis?
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.
