Liquidity (Edexcel IGCSE Business)
Revision Note
Written by: Lisa Eades
Reviewed by: Steve Vorster
The Importance of Liquidity
Liquidity is defined as the ability of a business to pay back its short-term debts, e.g. its suppliers
A businesses that cannot pay its debts is considered insolvent
If a business cannot pay its suppliers, raw materials or components may not be delivered and production will be delayed
If it cannot repay an overdraft, banking facilities may be withdrawn, and its credit rating will suffer
Creditors may force it to stop trading and sell its assets so that the debts owed to them are repaid
Stakeholders interested in liquidity include
Suppliers want to be reassured that a business is likely to be able to pay for them
Financial providers such as banks want evidence that a business is likely to be able to repay loans or overdrafts
Customers want to be sure that a supplier will be able to produce and deliver goods it orders
Liquidity Ratios
The liquidity of a business can be measured using two ratios
Current ratio
Acid test ratio
The Current Ratio
The Current Ratio is a quick way to measure liquidity
The outcome is expressed as a ratio
All types of current asset are included in calculating this ratio
The result indicates how many £s (or other currency units) of current assets are available to cover each £1 (or other currency unit) of short-term debt
It is calculated using the formula
Worked Example
Packer Sports Ltd has current assets of $15,545, current liabilities of $5,060 and an inventory figure of $8,250.
Calculate Packer Sports Ltd.’s current ratio. [2]
Step 1: Substitute the values into the equation
[1 mark]
Step 2: Express the outcome as a ratio
[1 mark]
In this example, Packer Sports Ltd has $3.07 of current assets to cover each $1 of short-term debt
The Acid Test Ratio
The acid test ratio is a precise and realistic way to measure liquidity, especially for businesses that hold large amounts of inventory
It is expressed as a ratio
It is also known as the liquid capital ratio
The least liquid form of current assets (inventory) is deducted so the acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly
It often takes time to sell inventory so it is excluded
The Acid Test is calculated using the formula
Worked Example
Packer Sports Ltd has current assets of $15,545, current liabilities of $5,060 and an inventory figure of $8,250.
Calculate Packer Sports Ltd’s acid test ratio. [3]
Step 1: Subtract inventory from current assets
[1 mark]
Step 1: Substitute the values into the equation
[1 mark]
Step 2: Express the outcome as a ratio
[1 mark]
In this example, Packer Sports Ltd has $1.44 of the most liquid current assets to cover each $1 of short-term debt
Analysing Liquidity
Comparing Liquidity
Businesses compare and monitor liquidity over time
A business may be able to identify a pattern of periods of good and poor liquidity
For some businesses poor liquidity can be seasonal
E.g. Low sales often follow major public holidays such as Christmas
Steps can be taken to improve the liquidity position at these times
E.g. Short-term finance such as overdrafts can be arranged
The impact on liquidity of spending decisions can be determined
Budgets that ensure a healthy liquidity position can be set
Capital expenditure could be delayed to avoid liquidity problems
Comparing liquidity between different businesses is problematic
Some businesses can survive on very low ratios
Businesses that have a high level of inventory turnover and sell for cash can have very low liquidity ratios
In 2023 Tesco Plc, the UK's largest supermarket, had a current ratio was just 0.71:1
Businesses that sell small volumes of expensive products, often on credit, require much higher liquidity ratios
In 2023 LVMH Group, owner of brands including Louis Vuitton and Acqua di Parma, had a current ration of 4.34:1
Improving Liquidity
A business will often need to take quick, decisive steps to improve their liquidity
Diagram: Ways to Improve Liquidity
Liquidity can be improved in a number of ways
Methods to Improve Liquidity
Method | Explanation |
---|---|
Manage the business better |
|
Reduce the credit period offered to customers |
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Ask suppliers for an extended repayment period, e.g an extension from 60 to 90 days |
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Make use of overdraft facilities or short-term loans |
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Sell off excess inventory |
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Sell assets and lease fixed assets instead (e.g. sale & leaseback) |
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Introduce new capital and reduce drawings out of the business |
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Examiner Tips and Tricks
In the exam, you could be asked to compare two ways to improve liquidity and make a recommendation. You may consider factors such as how quickly cash is needed, how much cash is needed, and how the methods may affect the business's ability to continue to operate effectively.
For example, selling assets may raise a large amount of finance, but it is unlikely to be a quick solution, and the business may be unable to operate effectively without key equipment or buildings.
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