Liquidity (Edexcel A Level Business)

Statement of Financial Position (Balance Sheet)

• The Statement of Financial Position contains the financial information required to draw conclusions about the liquidity of the business

  • Liquidity is the ability of a business to meet its short term commitments (e.g. payments to creditors) with its available assets

  • A business that cannot pay its bills will usually fail very quickly, even if they are profitable

  • Managing liquidity is a key way to manage risk in a business - and helps a business to prepare for the unexpected

• The Statement of Financial Position shows the financial structure of a business at a specific point in time

  • It identifies a businesses assets and liabilities and specifies the capital (money) used to fund the business

  • The Statement of Financial Position is also known as the Balance Sheet

An Example of a Statement of Financial Position for Packer Sports Ltd

Ways to Measure Liquidity

• The liquidity of a business can be measured using two ratios, the current ratio and the acid test ratio 

The Current Ratio

• The Current Ratio is a quick way to measure liquidity and the outcome is expressed as a ratio

• All forms of current asset are considered in this ratio

• The current ratio is an effective liquidity measure for businesses that hold little stock

• The result indicates how many £s of current assets it has available to cover each £1 of short term debt

• It is calculated using the formula

The Acid Test Ratio

• Is a precise way to measure liquidity and is expressed as a ratio

• The acid test ratio is also known as the liquid capital ratio

• The least liquid form of current assets (inventory/stock) is deducted so the acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly

• It is a particularly important measure of liquidity for businesses that hold a large amount of stock

• It is calculated using the formula

Ways to Improve Liquidity

• The best way to improve liquidity is to manage the business better

  • Use cash flow forecasts to identify potential cash flow issues before they arise - and take appropriate action

  • Budget effectively and consider adopting zero budgeting to carefully control spending

  • Set clear financial objectives and look for ways to reduce costs and increase income wherever possible

Methods to Improve Liquidity

Managing Working Capital

• Working capital is the money that a business has to fund its day to day activities

• It is often described as net current assets on the Statement of Financial Position

• Working capital is calculated using the formula

Current Assets - Current Liabilities

Managing Working Capital

• Working capital is described as the lifeblood of a business because a lack of it often leads to business failure as a business cannot meet its immediate financial obligations

  • Cash is the most liquid of a business's current assets and can be used to settle debts immediately

• Effective management of working capital involves careful cash management

  • Debtors and inventory (e.g. stock) are less liquid

  • Businesses that are struggling with a lack of working capital may look to convert these current assets into cash as quickly as possible (e.g. by selling the stock at lower prices or by more purposefully chasing payment from customers)

  • Requesting an extension of payment terms from suppliers can increase working capital in the short term as cash remains in the business for longer

  • Making use of short-term borrowing options such as overdrafts can improve a businesses working capital situation as it can access more cash than it has in its current account

• A business can have too much working capital

  • If a business is holding large amounts of cash it is likely to be missing out on the benefits of investing it in fixed assets or investments

  • This may represent a significant opportunity cost especially when interest rates are high

  • If a business is holding large amounts of inventory it may incur extra storage costs (e.g. security and handling costs) and could use the cash ‘tied up’ in this stock for other purposes