2.3.2 Liquidity | Edexcel A Level Business Revision Notes 2017 (2024)

A LevelBusinessEdexcelRevision Notes2. Managing Business Activities2.3 Managing Finance2.3.2 Liquidity

Test Yourself

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 assetsand liabilitiesand 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

$\frac{Current Assets}{Current Liabilities} = ? : 1$

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

£15,545 ÷ £5,060 = 3.07 (1 mark)

Step 2: Express the outcome as a ratio

= 3.07: 1 (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

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

$\frac{Current Assets - Inventory}{Current Liabilities} = ? : 1$

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

£15,545 - £8,250 = £7,295 (1 mark)

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 budgetingto carefully control spending
- Set clear financial objectives and look for ways to reduce costs and increase income wherever possible

Methods to Improve Liquidity

Method	Explanation
Reduce the credit period offered to customers	Collecting money owed from customers more quickly will increase the level of current assets in the business Customers may move to competing businesses that offer better credit terms
Ask suppliers for an extended repayment period e.g an extension from 60 to 90 days	Current liabilities will not be reduced The business can use cash it would have paid to suppliers for other purposes Suppliers may be unwilling to extend credit terms
Make use of Overdraft facilities or short-term loans	Current liabilities will increase The business can spend more money than it has in its bank account Banks may be reluctant to lend to businesses with cash-flow problems
Sell off excess stock	Less liquid current assets will be reduced and converted into more liquid forms of current asset (e.g. cash) Storage and security costs may also be reduced Stock may need to be sold at a low price to attract sales
Sell assets and lease fixed assets instead (e.g. Sale and Leaseback)	Both current assets and current liabilities will increase The business will continue to have the use of assets but must make regular payments to the leasing company
Introduce new capital and reduce drawings from the business	Current assets will be increased New capital may be introduced by the owner or from additional investors This may result in the dilution of controlof the business

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

Worked example

Garrick Components Ltd is a heating components business based in Tamworth. It has been struggling to control its level of inventories. Its customers are the country’s leading gas boiler manufacturers,. They require Garrick Components Ltd to supply products ‘just in time’ and as a result they must hold large amounts of varied stock to ensure that their customer’s needs can be met. Garrick Components offers its customers 90-days credit terms.

Financial Information for Garrick Components Ltd

	2022 £m	2021 £m
Inventories	8.1	7.2
Trade Receivables	2.2	3.1
Cash	0.9	1.2
Short-term loan	6.4	4.4
Trade payables	5.1	5.9

Calculate Garrick Components Ltd’s working capital in 2021 and 2022 (3)

Step 1: Identify and calculate current assets and current liabilities for 2022 and 2021

Current assets $\begin{array}{rcl} 2022 & = & £ 8.1 m + £ 2.2 m + £ 0.9 m = £ 11.2 m \\ 2021 & = & £ 7.2 m + £ 3.1 m + £ 1.2 m = £ 11.5 m \end{array}$ (1 mark)

Current liabilities $\begin{array}{rcl} 2022 & = & £ 6.4 m + £ 5.1 m = £ 11.5 m \\ 2021 & = & £ 4.4 m + £ 5.9 m = £ 10.3 m \end{array}$ (1 mark)

Step 2: Subtract current liabilities from current assets for 2022 and 2021

$\begin{array}{rcl} 2022 & = & £ 11.2 m - £ 11.5 m = (£ 0.3 m) \\ 2021 & = & £ 11.5 m - £ 10.3 m = £ 1.2 m \end{array}$ (1 mark)

Managing Working Capital

Working capital is described as the lifeblood of a business because a lack of working capital often leads to business failure as a business cannot meet its immediate financial obligations
- Cash is the most liquidof 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 costespecially 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

Exam Tip

A common exam error is the confusion between working capital and cash. Whilst working capital includes cash, it also includes less liquid current assets (e.g. trade receivables and inventory). These less liquid assets cannot be used to pay bills and so, whilst a business may have a positive working capital figure, it may still fail because it cannot meet its immediate financial commitments.

You've read 0 of your 0 free revision notes

Get unlimited access

to absolutely everything:

Downloadable PDFs
Unlimited Revision Notes
Topic Questions
Past Papers
Model Answers
Videos (Maths and Science)

Join the 80,663 Students that ❤️ Save My Exams

the (exam) results speak for themselves:

FAQs

2.3.2 Liquidity | Edexcel A Level Business Revision Notes 2017? ›

2. Liquidity - means the ease and cost with which assets can be turned into cash and used immediately as a means of exchange. Statement of financial position (balance sheet) - A formal financial document that summarises the net worth of a business at a given point in time.

Tell Me More ›

How to calculate liquidity business a level? ›

The Liquid Capital Ratio (Acid Test Ratio)

The liquid capital ratio focuses solely on cash and debtors as current assets. To calculate the liquid capital ratio, follow these steps: Subtract the inventory value from the total current assets. Divide the result by the total current liabilities.

Read On ›

What does a liquidity ratio of 2.5 mean? ›

The current ratio for Company ABC is 2.5, which means that it has 2.5 times its liabilities in assets and can currently meet its financial obligations Any current ratio over 2 is considered 'good' by most accounts.

Is 2 a good liquidity ratio? ›

Liquidity ratios are important to investors and creditors to determine if a company can cover their short-term obligations, and to what degree. A ratio of 1 is better than a ratio of less than 1, but it isn't ideal. Creditors and investors like to see higher liquidity ratios, such as 2 or 3.

What does liquidity mean in a level business? ›

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

Learn More Now ›

What is the formula for calculating liquidity? ›

Fundamentally, all liquidity ratios measure a firm's ability to cover short-term obligations by dividing current assets by current liabilities (CL).

Learn More Now ›

What is the formula for liquidity? ›

It is calculated by dividing total current assets by total current liabilities. A higher ratio indicates the company has enough liquid assets to cover its short-term debts. In comparison, a low ratio suggests that the company may not have enough cash or other liquid assets to cover its immediate liabilities.

Learn More ›

What does a current ratio of 2.3 mean? ›

On the other hand, a company with a current ratio greater than 1 will likely pay off its current liabilities since it has no short-term liquidity concerns. An excessively high current ratio, above 3, could indicate that the company can pay its existing debts three times.

Read The Full Story ›

What is a good level of liquidity? ›

A good current ratio is between 1.2 to 2, which means that the business has 2 times more current assets than liabilities to covers its debts. A current ratio below 1 means that the company doesn't have enough liquid assets to cover its short-term liabilities.

Learn More Now ›

What is a 2.1 liquidity ratio? ›

So a ratio of 2.1 means that a company has twice as much in current assets as current debt. A ratio of 1:1 means the total current assets are equivalent to the total current debt.

Show Me More ›

What is a good liquidity ratio for a business? ›

In short, a “good” liquidity ratio is anything higher than 1. Having said that, a liquidity ratio of 1 is unlikely to prove that your business is worthy of investment. Generally speaking, creditors and investors will look for an accounting liquidity ratio of around 2 or 3.

Learn More ›

What is a bad liquidity ratio? ›

Low current ratio: A ratio lower than 1.0 can result in a business having trouble paying short-term obligations. As such, it may make the business look like a bigger risk for lenders and investors.

What is a reasonable liquidity ratio? ›

2) On Hand Liquidity Ratio: This point-in-time ratio, often called the Primary Liquidity Ratio, assesses a bank's ability to satisfy liabilities with on-balance sheet high-quality liquid assets (HQLA). A minimum of 25% is recommended, with less than 15% warranting a Contingency Funding Plan action.

Get More Info Here ›

Do you want high or low liquidity? ›

A company's liquidity indicates its ability to pay debt obligations, or current liabilities, without having to raise external capital or take out loans. High liquidity means that a company can easily meet its short-term debts while low liquidity implies the opposite and that a company could imminently face bankruptcy.

What is an example of a business liquidity? ›

All businesses will have assets which are highly liquid and ones which are not. Cash is the most liquid of all but other assets with high liquidity include shares or inventory provided you can sell it quickly. Assets with low liquidity include property or large, expensive equipment, which take longer to sell.

Keep Reading ›

Why is liquidity important in business a level? ›

Liquidity refers to how easily a company can convert its assets into cash. High liquidity suggests quick convertibility, which can be crucial in meeting short-term obligations. Working capital is the difference between a company's current assets and its current liabilities.

Find Out More ›

Is a quick ratio of 2.5 good? ›

What is a good quick ratio for a company? A quick ratio above one is excellent because it shows an even match between your assets and liabilities.

Read The Full Story ›

What does a liquidity ratio of 1.5 mean? ›

A current ratio of 1.5 would indicate that the company has $1.50 of current assets for every $1 of current liabilities. For example, suppose a company's current assets consist of $50,000 in cash plus $100,000 in accounts receivable. Its current liabilities, meanwhile, consist of $100,000 in accounts payable.

Get More Info ›

What does a liquidity ratio of 1.4 mean? ›

What does a current ratio of 1.4 mean? For each $1 of inventory, the company has about $1.40 of current liabilities. For each $1 of current assets, the company has about $1.40 of current liabilities.

Know More ›

What does a liquidity ratio of 0.5 mean? ›

A low liquidity ratio, such as 0.5, indicates that a company does not have enough current assets to cover their current liabilities.

Know More ›