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2.3.2 Liquidity

This document discusses liquidity and working capital management. It defines key terms like current ratio, acid test ratio, and working capital. It also provides examples of calculating liquidity ratios using financial statements and interpreting the results.

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relchen.torrejas
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59 views

2.3.2 Liquidity

This document discusses liquidity and working capital management. It defines key terms like current ratio, acid test ratio, and working capital. It also provides examples of calculating liquidity ratios using financial statements and interpreting the results.

Uploaded by

relchen.torrejas
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Edexcel A2 Business

2.3.2 Liquidity

Revisionstation
Calculators will be needed for this topic
Worksheet
From Edexcel
a) Statement of financial position (balance sheet):
• measuring liquidity:
• calculating current ratio and acid test ratio
• ways to improve liquidity

b) Working capital and its management: the importance of cash


Starter
• You owe some people money, this is your financial liability
• Which one item that you own do you think would be the quickest to
sell if you needed to raise cash in a hurry?

• This is your most liquid item; it is an asset to you


• You can turn your assets into cash to pay your liabilities
Definition: Liquidity
• The ability of a business to turn its assets into cash to pay its current
liabilities
Liquidity – turning assets into cash
• The ability of a business to turn
its assets into cash
• The least liquid assets are listed
at the top of the statement of
financial position (balance sheet)
– premises and specialist
machinery for example may take
a while to sell, while stock is easy
to sell on
• Cash is the most liquid asset of all
Statement of financial position
Definiton: Statement of financial position
(balance sheet)
• A PLC (Public Limited Company) or a LTD (Private Limited Company)
business have to publish their accounts by UK law
• One of these accounts is the statement of financial position. In older
text books and on the Internet you may also see it called the balance
sheet

• In the exam you will NOT need to write one, but you will need to be
able look at an extract from one and make some calculations
This is the statement of
financial position for
Burberry for 2016 and
2017

Why do the liabilities


figures appear in brackets?
Statement of financial position - the exam
version

In the exam you are given


a much simpler version to
work with. This is an
example from the 2017
paper 3.
Measuring liquidity
• A business owner and their investors can use liquidity as a measure of
how healthy the business is, this it doesn’t have too many debts and
that it can easily pay its bills

• So we measure liquidity to find this out

• The tools to measure liquidity (ability to pay bills) is the statement of


financial position and two key ratios
• Current ratio
• Acid test ratio
Current ratio formula

Current assets
______________

Current
liabilities

Write down this formula and get out your calculator


and prepare to try some examples
Current ratio calculation
• Use the statement of financial position
to calculate the current ratio for
Burberry for 2016 and 2017
• Careful to only use the current asset
and current liability figures and not the
totals
• Express your answer as a ratio to 1

2016 :1

2017 :1
Current ratio answer
2016 2.77:1

2017 2.90:1

What conclusions can you make


from these ratios?
Some answers on the next slide
Current ratio analysis
Burberry has a current ratio of 2.9:1
This means that for every £1 of debts
they have £2.90 of assets that they can
quickly turn into cash
The Ideal ratio is 1.5:1, lower than this
and there is not enough money to pay
bills
Higher than this and there is too much
money tied up in stock – but with
Burberry being a high end retailer the
current ratio looks about right for
holding high value of stock
Acid test ratio formula

Current assets - inventory


_______________

Current liabilities

Write down this formula and get out your calculator


and prepare to try some examples
Acid test ratio calculation
• Use the statement of financial position
to calculate the acid test ratio for
Burberry for 2016 and 2017
• Careful to only use the current asset
and current liability figures and not the
totals
• Express your answer as a ratio to 1

2016

2017
Answer

2016 1.87:1

2017 2.01:1

Now that the inventory or stock


has been removed – what
conclusions can you make
about the ability of Burberry to
meet their day-to-day bills?
Acid test conclusions
A. This is also known as the quick ratio and is a harsher test of liquidity
because you cannot guarantee to sell all of the stock. Stock can also
spoil, become obsolete or just go out of fashion.
B. If a business has an acid test ratio of less than 1:1 then its current
assets (minus stocks) do not cover its current liabilities.
C. This could mean a problem for the business
D. Again some retailers with strong cash flow and fast moving stocks
may have an acid test of 0.4:1 and be fine, it depends on the
industry
Ways that liquidity can be improved
• A business could reduce the amount
of stocks that it holds, so finished
goods need to be dispatched faster to
customers
• A business could reduce the credit
period offered to customers, for
example insist that customers pay in
30 days not 90
• A business could also pay suppliers
later on agreed credit terms
• Increase borrowing long term and
clear the short term debts
Working capital and its management:
the importance of cash
Definition: Working capital
• Working capital means the day-to-day finance needed in a business
and can be calculated by CA-CL
Working capital cycle
Working capital cycle
The longer this How can a business
cycle takes, the improve their working
longer the cash is capital cycle?
tied up in stock or
owed by debtors Cash

Stock purchased from Cash paid by debtors for


suppliers on credit goods or services bought
(current liability) (current asset)

Sales
Revision Video
Sample Edexcel A2 questions
Case study for question 1
Sample question 1

Knowledge Application
1 3
Answer sample question 1
Case study for question 2
Sample question 2

Knowledge Application
1 3
Answer sample question 2
Glossary
• Liquidity; The ability of a business to turn its assets into cash to pay its current
liabilities
• Balance sheet; a snapshot valuation of the business, what it owes, what it owns
and owner equity
• Current assets (CA); items the business owns that will become cash within one
year e.g. stock or debtors
• Current liabilities (CL);items the business owes to others that must be paid within
one year e.g. credit from suppliers
• Current ratio; CA / CL
• Acid test ratio; CA – stock / CL
• Working capital; day-to-day money needed by a business to pay its bills on time
These are the ratios you need to learn for this
unit

Which is the formula for the current ratio and which is the formula for the acid test ratio?

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