Theme 2 - 2.3.2 - Liquidity Flashcards
Insolvent =
Bankrupt
What does liquidity mean ?
It’s how quick a business can get their hands on cash - for e.g. from savings etc
The ability of a business to turn its assets into cash to pay its current liabilities
Why do you need cash ?
To pay bills etc
Whats another way of saying statement of financial position ?
Balance sheet
Whats the most liquid asset of all ?
Cash
What is listed at the top of the statement of financial position ?
The least liquid assets are listed at the top of the statement of financial position - premises and specialist machinery for .g. May take a while to sell, while stock is easy to sell on
Whats a statement of financial position (balance sheet) ?
A PLC or a LTD business have to publish their accounts by UK law
One of these accounts is the statement of financial position.
What are fixed assets ?
They are non current assets like:
- Property
- Equipment
- Vehicles
They are assets that are long term meaning that the business acquires them to USE THEM and they are in the business for a long time - employees although are not fixed assets as the business cannot own you
What are the tools to measure liquidity ( ability to pay bills ) ?
Statement of financial position and 2 key ratios:
- Current ratio
- Acid test ratio
What are current assets ?
They are things that the business owns with the intention to turn them into cash - that’s why cash is the most liquid - it is already in the form that we need
E.g:
- inventory ( stock )
- cash in the bank
- trade receivable ( debtors - the people who owe money to the business )
What is the current ratio formula ?
Current ratio = Current assets / current liabilities
Whats an acid test ratio formula ?
Acid test ratio = Current assets - inventory / current liabilities
What ways can liquidity be improved ?
- A business could reduce the amount of stocks that it holds - this is because you quickly sell your stock and get cash for this
- A business could reduce the credit period to customers, for e.g. make customers pay in 30days and not 90days - this is because the customers own you money - the people that owe money to the company are called debtors
- A business can also pay the suppliers later on agreed credit terms and this means that they wont have to pay suppliers for that month for e.g. so they have more cash
- Increase borrowing ( cash ) long term - so obviously you borrow money so your more liquid and clear short term debts
Whats working capital ?
Working capital means the day to day finance ( for e.g. bills ) needed in a business and can be calculated by Current assets - current liabilities.
If the business runs out of working capital then it should stop trading - because you have run out of money to do day to day to run the business - you have more money coming in than
What are some current liabilities ?
- trade payables ( creditors )
- bank overdraft
What are some non-current liabilities ?
Long term liabilities
-Bank loans
-Mortgage
-Lease
What is the working capital cycle ?
Cash —> cash paid by debtors for goods and services ( current asset ) so the business receives money —> sales —> stock purchased from suppliers on credit ( current liability ) —> Cash
its good only if everyone does their job - the money that the business gains from the debtors is used to pay the suppliers and if the debtors are late on paying the business then the business wont be able to pay the suppliers in time so the supplier might stop working with them etc etc. Also if the stock doesn’t get sold - bad sales then you also wont be able to pay the suppliers
The longer this cycle takes the longer the cash is tied up in stocks or owed by debtors
What is the acid test conclusion ?
This is also known as the quick ratio and is a harsher test of liquidity because you cannot guarantee to sell all of the stock - stock can also spoil become obsolete or just go out of fashion
If a business has an acid test ratio of less than 1:1 then its current assets do not cover its current liabilities
