2.3.2 Liquidity

• Definition 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
• Liquidity Ratios:

  • A business owner and their investors can use liquidity as a measure of how healthy the business is.
  • The tools to measure liquidity (ability to pay bills) is the statement of financial position and two key ratios:
  • Current ratio
  • Acid test ratio
• Current Ratio:

  • Assesses whether or not a business has enough resources to meet any debts that arise in the next 12 months.
  • Ideal ratio is 1.5:1
  • Lower than this and there is not enough money to pay bills
  • Higher than this the money is not “working hard” enough and should be invested into non-current assets
• Current Ratio = Current assets / Current liabilities
• Acid Test Ratio:

  • Similar to the current ratio but excludes stocks from current assets. A more severe test of liquidity.
  • 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.
• Acid-test ratio = (current assets - stocks) / current liabilities
• Method of improving Liquidity & will it work?

  • Reduce stock levels - A business could reduce the amount of stocks that it holds, so finished goods need to be dispatched faster to customers
  • Change credit terms - A business could reduce the credit period offered to customers, for example insist that customers pay in 30 days not 90 days
  • Change supplier payment terms - A business could also pay suppliers later on agreed credit terms
  • Change borrowing - Increase borrowing long term and clear the short-term debts
• Payables

  • People who are owed money by the business. Usually, suppliers awaiting payment, but they may be traders who have supplied services, such as gas, electricity and telephone systems. Payables are also known as Creditors
• Receivables

  • People who owe the business money. Usually customers who have been given credit terms. Receivables are also known as Debtors
• • The working capital (current assets - current liabilities) of a firm provides an indication of a firm's ability to pay its short-term debts.

  This is because it includes a firm's most liquid assets (the current assets), but excludes the non-current assets, such as property which may take a long time to sell.
• The length of the working capital cycle is calculated by studying the three main elements of working capital;

  • Inventories
  • Receivables
  • Payables
• Working capital cycle = Length of time goods are held as inventories + time taken for receivables to be paid - period of credit received from suppliers (payables).