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2.3.2 Liquidity

A) Statement of financial position (Balance sheet)

Current assets – These are assets which the business is able to turn into cash quickly. The most liquid asset that a business has is cash.

Current liabilities – These are short term debts/obligations which the business will need to pay in the short term e.g. bills.

Non-current assets – These are assets which cannot easily be turned into cash e.g. property.

Non-current liabilities – These are debts/obligations which the business will have to pay in the long term (not the short term) e.g. long term loans.

Liquidity – The ease at which a business can turn its assets into cash immediately in order to pay its current liabilities.

Balance sheet – This is a document showing a snapchat of the assets and liabilities of a business giving an insight into the liquidity of the business.

Measures of liquidity

  • Current ratio = Current assets/Current liabilities
  • Acid test ratio = Current assets – Stock/Current liabilities

The current account ratio shows how able a business is to pay off its current liabilities. The higher the current ratio figure, the more able a business is to pay off their current liabilities. The acid test ratio is a more strict measure of liquidity. This is due to the fact that it does not make the assumption that all stock/inventory will be sold which is in contrast to the current ratio. As a result of this, a business’s acid test ratio is likely to be much lower than their current ratio.

Ways to improve liquidity:

Reduce credit period offered – By doing this it means that the business will be able to increase its short term assets.

Pay suppliers later – By doing this it will reduce the amount of current liabilities that the business has. Through delaying the payment it will result in it becoming a non-current liability thus improving the short term liquidity of the business.

Increase long term borrowing – Although this will increase non-current liabilities, it will help to clear short term debts thus reducing current liabilities and therefore improve the liquidity of the business.

 

B) Working capital and its management

Working capital – This is the money that the business has available to meet its day to day activities.

Working capital = Current assets – Current liabilities

Cycle of working capital = Stocks ordered form supplier – production turns stocks into products (outflow of cash paid to suppliers) – products held until a customer is found – products sold to customers – customers pay for their purchase (inflow of cash paid by customers).

If the business’s current assets are less than their current liabilities then they will have trouble paying their short term debts due to a lack of cash. Therefore the business is at risk of failing and going bankrupt. It is important that businesses mange the amount of working capital that they have in order to prevent shortages of cash.

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