Business 2.3.2 Liquidity

• What is a statement for financial position?

  
  

  A ‘snapshot’ of the financial position of a business on a particular day ( usually the last day of the financial year )

  
  

  A statement of financial position which shows assets ( what is owned and owed ), liabilities ( what it owes ) and total equity ( share capital and retained profit )
• Calculations that a required within a statement of financial position are:

  • Net Assets = Non - current assets + current assets ) - ( Current liabilities + non - current liabilities )
  • Total equity = Share capital + retained profit

  ( Total equity is also known as Shareholder’s funds )
• What are non-current assets?

  Assets kept for more than one year
• Why are non-current assets important for a business?

  They represent long-term investments for operations
• What are current assets?

  Assets expected to be turned into cash within a year
• How do current assets affect a business's liquidity?

  They provide cash flow for short-term obligations
• What are current liabilities?

  Amounts owed to be paid off within a year
• Why is it important to track current liabilities?

  To manage short-term financial obligations effectively
• What are non-current liabilities?

  Amounts owed not due within the next year
• How do non-current liabilities impact a business's financial health?

  They indicate long-term financial commitments
• What is share capital?

  Money raised via the sale of shares
• Why is share capital significant for a business?

  It provides funding for operations and growth
• What is retained profit?

  Money retained instead of distributed to shareholders
• How does retained profit benefit a business?

  It can be reinvested for growth and expansion
• What are the key components of a statement of financial position?

  • Non-current assets
  • Current assets
  • Current liabilities
  • Non-current liabilities
  • Share capital
  • Retained profit
• What does liquidity do?

  Assesses whether a business has sufficient cash or equivalent current assets to be able to pay its debts as they fall due
• There are 2 ratios that can help assess the liquidity position of a business:

  • Current Ratio
  • Acid - Test Ratio
• What does the Current Ratio do?

  Compares the current assets of a business with its current liabilities.
• What is the calculation for Current Ratio?

  Current Assets / Current Liabilities
• • A Current Ratio between 1.5 - 2 = efficient management of working capital
  • A low Current Ratio = cash problems
  • A high Current Ratio - holding too much cash / inventory or customers taking too long to pay
  • However, it’s important to consider the nature of the business and the industry it operates in
• What does the Acid - Test ratio do?

  Discounts inventory from the ratio calculation.

  • A business may have what appears to be a healthy current ratio but if the business is holding a lot of inventory, it may be difficult to turn this into cash as there is no guarantee that a business can sell its stock
• What is the calculation for Acid - Test ratio?

  Current Assets - Inventory / Current Liabilities
• • If Acid - Test Ratio = significantly less than one = problems ( won’t have enough to cover liabilities )
  • Some businesses can operate with relatively low acid test ratios especially with high stock turnover
  • Its important to compare with previous years because if falling = problems
• Ways to improve liquidity:

  • Negotiate better credit terms with suppliers
  • Reduce customer credit terms
  • Better credit control
  • Overdraft
• Negotiate better credit terms with suppliers:

  Extending time with suppliers means it takes longer for cash to leave the business. This may impact supplier relationships and some may refuse to offer further credit facilities ( especially for smaller and newer businesses which are perceived as higher risk )
• Reduce Customer Credit terms:

  Cash can flow into the business quicker but this can result in customers switching to businesses with more favourable credit terms
• Better Credit Control:

  A business can carry out extra credit checks to reduce debtors and / or offer cash discounts.
• Overdraft:

  Help improve liquidity position of a business by increasing current overdraft limit but a business with liquidity problems may struggle to convince a bank to set up / extend an overdraft
• What is the definition for Working Capital?


  The amount of money a business needs to pay for its day - to - day trading
• What is the calculation for Working Capital?

  Current Assets - Current Liabilities
• Working Capital and its management: The importance of cash

  A business needs enough to pay staff wages when they are due and to pay suppliers when invoice payment terms are reached.

  Important both in the short - term and the long - term, the challenge is to maintain sufficient liquidity, to ensure the business can survive and grow.
• Working Capital and its management: The importance of Cash

  • The current liabilities show the amounts that need to be paid in the next 12 months.
  • Current assets show the cash / other assets like inventory that are available to settle those current liabilities.
• What is the working capital cycle?

  How the business is constantly selling liabilities, taking money from customers and buying inventories and so on.

  ( A statement of financial position is just a ‘snapshot’ of this )
• What are the components of the Working Capital Cycle?

  • Inventories are ordered from the supplier
  • Production turns inventory into products
  • (Outflows - cash paid to suppliers / employees )
  • Finished goods held until a customer found
  • Products sold to customers
  • Customers may for their purchases - to settle any liabilities in the business
  • (Inflows - cash paid by customers )
• • The working capital cycle can often be expressed as a time period.
  • An increase in length could mean it is taking longer to turn stock / receivables into cash.
  • Each time through the cycle, a little more money is put back into the business than flows out.
  • But if management don’t carefully monitor cash - flow and take corrective action when necessary = trouble
  • The cash needed to make the cycle above work effectively = WORKING CAPITAL
• • It is crucially important that a business actively manages working capital.
  • Cash is of extreme importance as is the timing of cash flows
  • Just because a business is making a profit does not necessarily mean that there is cash coming into and out of the business