Liquidity (Edexcel IGCSE Business)

The importance of liquidity

Spec point — 3.5.1 · Calculating and analysing accounting ratios

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  • If it cannot repay an overdraft, banking facilities may be withdrawn, and its credit rating will suffer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

Spec point — 3.5.1 · Calculating and analysing accounting ratios: • current ratio • acid test ratio.

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

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

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 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

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

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 acid test ratio.

[3]

Step 1: Subtract inventory from current assets

\ 15 , 545 - $ 8 , 250

= $ 7 , 295$ [1 mark]

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 mark]

Step 2: Express the outcome as a ratio

$=1.44:1$ [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

Spec point — 3.5.2 · Liquidity: • the concept and importance of liquidity • comparisons with previous years and/or with other business organisations.

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

Ways to improve liquidity

*Liquidity can be improved in a number of ways *

Methods to improve liquidity

Exam Hint 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.