finance exam - liquidity financial ratio Flashcards
what is liquidity
liquidity is the ability of a business to meet its short term financial commitments
what is the liquidity financial ratio
current assets/current liabilities
what are the three types of names provided to the liquidity ratio
-liquidity ratio
-working capital ratio
-current ratio
what is the aim of this ratio?
used to assess the ability of a business to turn their assets into cash in order to meet their short term obligations.
-bring upon short term financial stability of business
what is the industry benchmark
2:1
comment on 2018 liquidity ratio
for every $1 in current liabilities, there is $1.12 in current assets
comment on 2019 liquidity ratio
for every $1 in current liabilities, there is 1.54 cents in current assets
why is a comparative ratio important
Comparative ratio analysis can be used to compare the business with others in the industry (benchmarking) against common standards and overtime.
comment on the comparative ratio between 2018-2019 liquidity
-an increase in 42 cents which is good for a business as it means there is more in assets. however, in regard to optimum ratio, it isn’t considered low but not at its best.
why is it important to have more assets than liabilities(4)
- ensures liquidity ofc
- creditworthiness
A higher ratio of current assets to current liabilities signals to creditors that the business is in a better position to repay its debts in the short term.
-Risk Management
-stability
what is working capital management and what does it represent
basically liquidity -
- represents the funds that are needed for the day-to-day operations of a business to produce profits and provide cash for short term liquidity
what happens if a business is too liquid? ratio is too high
it reflects inefficient use of resources and the lack of focus on revenue
what happens if a business is not liquid enough? ratio is too low
Profitability will need to be maximised or the business may be seen as vulnerable and insolvent and can have creditors taking court action to receive payment.
why is the control of current assets extremely important?(3)
- Requires management to select the optimal amount of each current asset held as well as raising the finance accordingly required to fund those assets
- Costs and benefits of holding too much or too little of each asset MUST BE ASSESSED
- The working capital should be sufficient to maintain liquidity and have access to overdraft
in order to control current assets, the three things that must be assessed are…
- cash
- accounts receivables
- inventories
how can cash be efficiently managed?
a cash budget would be extremely beneficial. A cash budget is a detailed plan of the cash inflows and outflows of a business over a specified time. It is both a planning and controlling tool.
how do cash budgets measure the effectivity of a business in managing current assets
Easier to predict cash outflows > cash inflows
- Cash inflow focuses on customer demand which business has limited control over
- Cash outflows can be fairly accurately budgeted because it’s the business’s expenses
- Cash can be lost in theft, fraud or mismanagement so businesses do not like to hold too much cash- hence cash budgets allow businesses to plan an appropriate reserve of cash
why are accounts receivables important to manage?
- Customers do not always pay their debts on time
^ if this happens, it can be a real prob bc businesses may need those funds to meet its own commitments
hence, businesses must ensure debtors repay faster so they have to implement certain strats
what is the strat a business should apply to ensure debtors are paying their repayments on time (accounts receivables)
credit policy - defines how your company will extend credit to customers.
managers need to make a number of decisions about :
- Check credit ratings of prospective customers
- Setting up a reasonable repayment period (e.g., 30 days)
- Follow up on unpaid accounts
- Charging fees for late payments
It is important to establish A credit collection policy, which is a guide to staff on what to do if customer debts are not paid on time.
HOWEVER, If a credit policy is too strict, customers may go to a competitor.
why must inventories be managed in order to ensure current assets are managed
- Business holds stock in order to meet customer demand. If a business runs out of stock of finished goods the customer might go elsewhere and sales are lost.
- If it runs out of stock, it may cause the business to shut down the production process
what strat can be implemented to manage inventory
- Inventory should be controlled by having an inventory policy. Enables orders to suppliers to be quickly checked against inventories in stock
- JIT system
- Rate of Inventory turnover is extremely important to calculate to ensure a suitable management
what does the control of current liabilities consist
- accounts payable
- loans
- overdrafts
why are accounts payable important in the management of current liabilities? how can this be managed
(the debts owed to suppliers from the business)
If the accounts are paid too late, there is a danger of damaging the business’s credit rating, and the business may incur a late fee or interest for late payment.
MANAGED …
* ‘Stretching Accounts Payable’ : controlling accounts payable by paying them as late as possible without damaging credit rating.
- Taking advantage of discounts offered by creditors
why are LOANS important in the management of current liabilities? how can this be managed
Loans hold the costs of variable interest rates which can be a financial risk if it increases for the business and that short term loans can be extremely costly.
hence it is important for a business to control loans by investigating alternative sources of funds from dif banks & financial institutes
other strats include:
-comparing lenders
-negotiating lower interest
reworking loan terms
why are overdrafts important in the management of current liabilities? how can this be managed
well it has variable interest rate
faster loan repaid= less
slower= more interest
A business can control its overdraft by ensuring that all cash received is promptly deposited in the business’s overdraft account to reduce the amount owing.
what are the two broad stratefgies for managing working capital when the ratio is lower than the optimum ratio
- leasing
- sale and lease back
what is leasing and provide pros/cons on the strategy
(renting something off another business for a period of time at a fixed price)
It reduces the amount of finance borrowed by the business. It also enables the business to use the latest models (being more efficient).
- Businesses don’t have to worry about depreciation
- Tax deductible
- The business does not own the asset (liability)- renovations are not permitted
what is sale and leaseback and provide pros/cons on the strategy
The selling of an owned asset to a lessor (someone that leases property) and leasing the asset back through fixed payments for a specified number of years. The sale of an asset provides the business with immediate funds, which can be used in either cash or stock to boost working capital.
- Frees up cash to be used elsewhere
- Repayments can be matched with cash flow
- Depreciations doesn’t affect the business
- Repayments are tax deductible
- Can affect long term profitability as business incurs leasing expenses indefinitely
