Liquidity 2.3.2
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. It balances net assets (what you spent the money on?) with total equity (where you got the money from?)
Assets - include all things that could be of benefit to the organisation. Those that appear on the statement of financial position are the ones that can be given a money value
Liabilities - includes all debts that must be repaid at some point in the future.
Why are liquidity ratios important?
1) SUPPLIERS = They will want to see the health of a business before agreeing to trade credit
2) INVESTORS = Before lending money or buying shares, investors will want to see how healthy the business is (e.g. survival)
3) THE BUSINESS = How healthy are we? Can we afford to borrow more? e.g. overdraft, trade credit, loans). It can also use the ratios to compare performance either with competitors or from previous years.
Insufficient liquidity means not enough working capital. It is crucial that working capital is carefully managed, otherwise the business may not be able to pay its short-term debts. On the other hand, too much working capital can mean that the business should use this cash more productively elsewhere and make sure it is not an opportunity cost.
MEASURING LIQUIDITY - THE RATIOS
1) CURRENT RATIO
This shows the number of times by which liquid assets exceed current liabilities. It indicates whether the business can pay debts due within one year out of the current assets. The current ratio reveals how much "cover" the business has for every £1 that is owed by the firm. For example, a ratio of 1.5:1 would mean that a business has £1.50 of current assets for every £1 of current liabilities.
Current assets* / Current Liabilities = ? : ?*
*inventory is not covered in current assets as it is deemed the hardest to turn into cash quickly
*the answer is always expressed as a ratio
At 31 December 2010, current assets were 1.85 times the value of current liabilities. That ratio was more than the 1.7 times at the end of 2009, suggesting a slight improvement in the current ratio.
A current ratio of around 1.7 - 2.0 is pretty encouraging for a business. It suggests that the business has enough cash to be able to pay its debts, but not too much finance tied up in current assets which could be reinvested or distributed to shareholders. If it had a really good cash position, the business could look at investing in non-current assets as an opportunity cost.
A low current ratio (say less than 1.0 -1.5) might suggested that the business is not well placed to pay its debts. It might be required to raise extra finance or extend the time it tales to pay creditors.
HOWEVER... there is no such thing as an ideal current ratio (which is a good point to make in the exam). Different industries work with different levels of cover, so one current ratio may suit one business but not another. If all businesses in one market are working at a low current ratio, then its not a problem.
However, a ratio less than 1 is often a cause for concern, particularly if it persists for any length of time.
2) ACID TEST RATIO
Not all assets can be turned into cash quickly or easily. Some - notably raw materials and other stocks - must first be turned into a final product, then sold and the cash collected from debtors. The acid test ratio, therefore adjusts the current ratio to remove the value of stocks from the current assets total. This is because stocks are assumed to be the most illiquid part of current assets - it is harder to turn them into cash quickly.
LIQUID ASSETS (CURRENT ASSETS - STOCKS) / CURRENT LIABILITIES
An acid test of over 1.0 is generally good; the business should be able to pay its debts even if it cannot turn stocks into cash
Some care has to be taken interpreting the acid test ratio. The value of stocks a business needs to hold will vary considerably from industry to industry. For example, you wouldn't expect a firm of solicitors to carry much stock, but a major supermarket needs to carry huge quantities at any one time.
An acid test ratio for Tesco and ASDA would indicate a very low figure after taking off the value of stocks but leaving in the very high amounts owed to suppliers (trade creditors). However, there is no suggestion that either of these two businesses has a problem being able to pay the debts!
The trick is to consider what a sensible figure is for the industry under review. A good discipline is to find an industry average and then compare the current and the acid test ratios against for the business concerned against that average.
If acid test or current ratios come back as quite low, a business may look to improve its liquidity.
Statement of financial position (balance sheet) - A formal financial document that summarises the net worth of a business at a given point in time. It balances net assets (what you spent the money on?) with total equity (where you got the money from?)
Assets - include all things that could be of benefit to the organisation. Those that appear on the statement of financial position are the ones that can be given a money value
Liabilities - includes all debts that must be repaid at some point in the future.
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Assets are items of value owned by a business
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Liabilities are the money a business owes i.e. debts
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Non – current (fixed) assets
Likely to be kept by the business
for more than one year
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Current assets
Likely to be turned into cash within
a year
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Non – current liabilities
Debts that the business has more
than one year to repay
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Current liabilities
Debts that the business may have to
repay within one year
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Vehicles
Premises
Machinery
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Inventories (Stock)
Accounts Receivable (Debtors)
Cash and Cash Equivalents
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Bank loans
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Overdrafts
Accounts Payable (Creditors)
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Why are liquidity ratios important?
1) SUPPLIERS = They will want to see the health of a business before agreeing to trade credit
2) INVESTORS = Before lending money or buying shares, investors will want to see how healthy the business is (e.g. survival)
3) THE BUSINESS = How healthy are we? Can we afford to borrow more? e.g. overdraft, trade credit, loans). It can also use the ratios to compare performance either with competitors or from previous years.
NET ASSETS/WORTH = TOTAL EQUITY
Insufficient liquidity means not enough working capital. It is crucial that working capital is carefully managed, otherwise the business may not be able to pay its short-term debts. On the other hand, too much working capital can mean that the business should use this cash more productively elsewhere and make sure it is not an opportunity cost.
MEASURING LIQUIDITY - THE RATIOS
1) CURRENT RATIO
This shows the number of times by which liquid assets exceed current liabilities. It indicates whether the business can pay debts due within one year out of the current assets. The current ratio reveals how much "cover" the business has for every £1 that is owed by the firm. For example, a ratio of 1.5:1 would mean that a business has £1.50 of current assets for every £1 of current liabilities.
Current assets* / Current Liabilities = ? : ?*
*inventory is not covered in current assets as it is deemed the hardest to turn into cash quickly
*the answer is always expressed as a ratio
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Balance Sheet at 31 December
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2010
£’000
|
2009
£’000
|
|
Current assets
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6,945
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6,245
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|
Current Liabilities
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3,750
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3,680
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Current ratio
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1.85
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1.70
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At 31 December 2010, current assets were 1.85 times the value of current liabilities. That ratio was more than the 1.7 times at the end of 2009, suggesting a slight improvement in the current ratio.
A current ratio of around 1.7 - 2.0 is pretty encouraging for a business. It suggests that the business has enough cash to be able to pay its debts, but not too much finance tied up in current assets which could be reinvested or distributed to shareholders. If it had a really good cash position, the business could look at investing in non-current assets as an opportunity cost.
A low current ratio (say less than 1.0 -1.5) might suggested that the business is not well placed to pay its debts. It might be required to raise extra finance or extend the time it tales to pay creditors.
HOWEVER... there is no such thing as an ideal current ratio (which is a good point to make in the exam). Different industries work with different levels of cover, so one current ratio may suit one business but not another. If all businesses in one market are working at a low current ratio, then its not a problem.
However, a ratio less than 1 is often a cause for concern, particularly if it persists for any length of time.
2) ACID TEST RATIO
Not all assets can be turned into cash quickly or easily. Some - notably raw materials and other stocks - must first be turned into a final product, then sold and the cash collected from debtors. The acid test ratio, therefore adjusts the current ratio to remove the value of stocks from the current assets total. This is because stocks are assumed to be the most illiquid part of current assets - it is harder to turn them into cash quickly.
LIQUID ASSETS (CURRENT ASSETS - STOCKS) / CURRENT LIABILITIES
|
|
2010
£’000
|
2009
£’000
|
|
Current assets – inventories/stock
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5,620
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4,770
|
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Current liabilities
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3,750
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3,680
|
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Acid test ratio
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1.50
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1.30
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An acid test of over 1.0 is generally good; the business should be able to pay its debts even if it cannot turn stocks into cash
Some care has to be taken interpreting the acid test ratio. The value of stocks a business needs to hold will vary considerably from industry to industry. For example, you wouldn't expect a firm of solicitors to carry much stock, but a major supermarket needs to carry huge quantities at any one time.
An acid test ratio for Tesco and ASDA would indicate a very low figure after taking off the value of stocks but leaving in the very high amounts owed to suppliers (trade creditors). However, there is no suggestion that either of these two businesses has a problem being able to pay the debts!
The trick is to consider what a sensible figure is for the industry under review. A good discipline is to find an industry average and then compare the current and the acid test ratios against for the business concerned against that average.
IMPROVING LIQUIDITY
If acid test or current ratios come back as quite low, a business may look to improve its liquidity.
The aim is to increase current assets and/or reduce current liabilities
- Sell assets that are no longer being used i.e. turn them from a non-current/fixed asset to a current asset (cash)
- Move cash balances from current accounts to high interest bearing accounts so its value increase more rapidly
- Switch to long term sources of finance e.g. overdraft (short term) to a bank loan (long term)
- Monitor debtors to avoid bad debts
- Use creditors trade credit terms to the full
- Use a debt factoring service
- Sell surplus inventory
- Implement JIT system
- Raising the price to increase profit
- Sell more improves profitability of business
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