Liquidity Flashcards
What is liquidity?
The ability of a business to turn its assets into cash to pay its current liabilities.
Explain turning assets into cash in terms of liquidity.
The ability of a business to turn its assets into cash
The least liquid assets are listed at the top of the statement of financial position (balance sheet) – premises and specialist machinery for example may take a while to sell, while stock is easy to sell on
Cash is the most liquid asset of all
What is a statement of financial position?
shows the value of a business on a particular date, including its assets and liabilities.
What are current assets?
Current assets are the assets a business owns which are either cash, cash equivalents, or are expected to be turned into cash during the next twelve months. Current assets are, therefore, very important to cash flow management and forecasting, because they are the assets that a business uses to pay its bills, repay borrowings, pay dividends and so on. Current assets are listed in order of their liquidity – how easy it is to turn each category of current asset into cash.
What are non-current assets?
assets that the business has purchased and expects to keep in the business for more than one year. The most important component of non-current assets is “Property, Plant & Equipment” which refers to the business’ fixed assets such as buildings, land, vehicles, IT equipment and machinery.
What are current liabilities?
amounts that are owed by the business and which are due to be paid within the next twelve months. Current liabilities are normally settled from the amounts available in current assets.
What are non-current liabilities?
the monies the business has borrowed for a period of more than a year – mainly bank loans.
Why does business owners measure liquidity?
A business owner and their investors can use liquidity as a measure of how healthy the business is - that it doesn’t have too many debts and that it can easily pay its bills.
The statement of financial position as well as the current and acid test ratio are used to measure liquidity/ability to pay bills.
What is the current ratio formula?
current assets / current liabilities
this is expressed as a ratio to one
Explain current ratio analysis.
The Ideal ratio is around 2:1, lower than this and there is not enough money to pay bills
Higher than this and there is too much money tied up in stock – although high end retailers may be an exception
A current ratio of 2.9:1 means that for every £1 of debts they have £2.90 of assets that they can quickly turn into cash
What is the acid test ratio formula?
(Current assets - inventory/stock) / current liabilities
Explain acid test analysis.
This is also known as the quick ratio and is a harsher test of liquidity because you cannot guarantee to sell all stocks
If a business has an acid test ratio of less than 1:1 then its current assets (minus stocks) do not cover its current liabilities.
This could mean a problem for the business
What are some ways in which liquidity can be improved?
A business could reduce the amount of stocks that it holds, so finished goods need to be dispatched faster to customers
A business could reduce the credit period offered to customers, for example insist that customers pay in 30 days not 90
A business could also pay suppliers later on agreed credit terms
Increase borrowing long term and clear the short term debts (like overdrafts)
Sale and leaseback - assets including property and machinery can be sold to specialists in the market, and then leased back to the seller. This means cash can be raised and the business keeps the assets.
What is working capital?
Working capital means the day-to-day finance needed in a business
What is the formula for working capital?
Current assets - current liabilities
