Liquidity (Cambridge International IGCSE Business)

The concept of liquidity

• Liquidity refers to the cash and other current assets businesses have available to quickly pay bills and meet short-term financial obligations

• A business 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 may 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  • If it cannot repay an overdraft, banking facilities may be withdrawn, and its credit rating will suffer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

• The liquidity of a business can be measured using two ratios

  • Current ratio
  • Acid test ratio

Exam Hint A common misconception is thinking a high liquidity ratio is always good – in reality, too much cash or current assets may mean resources are not being used efficiently

Current ratio

Spec point — calculate and interpret liquidity ratios

• The current ratio 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

  • Its 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

• It is calculated using the formula

equation$\mathrm{Current} \mathrm{ratio}=\frac{\mathrm{Current} \mathrm{assets}}{\mathrm{Current} \mathrm{liabilities}}\,\,=?:1$

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 \div $ 5 , 060

= 3.07$ [1]

Step 2: Express the outcome as a ratio

$=3.07:1$ [1]

• Packer Sports Ltd has $3.07 of current assets to cover each $1 of short-term debt**

Acid test ratio

• The Acid Test Ratio (also called the Quick Ratio) is a measure of a business’s liquidity – how easily it can pay its short-term debts without relying on selling inventory (stock)

  • 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 business'sability 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

$\mathrm{Acid} \mathrm{test} \mathrm{ratio}=\frac{\mathrm{Current} \mathrm{assets}-\mathrm{Inventory}}{\mathrm{Current} \mathrm{liabilities}}\,\,=?:1$

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: Subtract inventory from current assets

\ 15 , 545 - $ 8 , 250

= $ 7 , 295$ [1]

Step 1: Substitute the values into the equation

$\text{Acid} \text{test} \text{ratio} = \frac{ \text{Current} \text{assets} - Inventory}{Current liabilities}

= \frac{ $ 7 , 295}{$ 5 , 060}

= 1.44$ [1]

Step 2: Express the outcome as a ratio

$=1.44:1$ [1] **

-** Packer Sports Ltd has $1.44 of the most liquid current assets to cover each $1 of short-term debt**