2.3.2-Liquidty

Question 1

What is liquidity?

Answer 1

Liquidity assesses whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due

Question 2

What ratios are used to assess the liquidity position of a business?

Answer 2

Acid test ratio
Current ratio

Question 3

What is the formula for current ratio?

Answer 3

Current ratio = current assets
——————-
Current liabilities

Question 4

How do we interpret the current ratio?

Answer 4

A ratio between 1.5 and 2 suggests a good liquidity position
Low ratio below 1 Means you can’t pay bills as they fall due
A high current ratio could mean the business is holding too much cash or inventory or allowing customers too long to pay. Shareholders wouldn’t want a high ratio as money is left sat in the bank (they won’t dividends or it to be reinvested)

It is important to compare the current ratio with previous years to see the trend
It is also important to consider the nature of the business and the industry operating for example supermarkets often operate with low current ratios as they are cash generating businesses.

Question 5

How do you calculate acid test ratio?

Answer 5

Acid test ratio= current assets - inventory
————————————
Current liabilities

Question 6

How do you interpret acid test ratio?

Answer 6

Ratio of significantly less than 1 could signal potential problems for the business
However, some businesses can operate with relatively low acid test ratios, especially those with high stock.
It is important to compare the ratio to previous years as a falling ratio can indicate liquidity issues

Question 7

How can a business improve its liquidity?

Answer 7

Negotiate better credit terms with suppliers - extending the time it takes for business to pay its suppliers means it takes longer for the cash to leave the business and therefore cash is retained longer however this may impact on supplier relationships and some suppliers may refuse to offer further credit facilities, especially for smaller or newer businesses perceived as higher risk

Reduce customers credit terms - a business could reduce the time it takes its customers to pay meaning the cash flows into the business quicker however this could result in customers switching to businesses with more favourable credit terms

Overdraft - arranging an overdraft or increasing the current overdraft limit can help improve liquidity position although a business with liquidity problems may struggle to convince a bank to set up or extend the overdraft

Question 8

What is working capital?

Answer 8

The amount of money a business needs to pay for its day-to-day trading

Question 9

How is working capital calculated?

Answer 9

Working capital = current assets - current liabilities