Liquidity 2 lessons covering liquidity. We will look at: a)What is meant by liquidity, measuring and calculating: – Current ratio – Acid test b)Ways to improve liquidity c)Managing working capital d)Reinforcement of the importance of cash

Statement of financial position (Balance Sheet) Balance Sheet All plcs have to publish documents showing financial performance including a statement of financial position, known as a balance sheet The balance sheet records all the assets and liabilities of a business. Liabilities are what the firm owes, such as bank loans Current liabilities are the bills which will need to be paid within 12 months – Trade payables are the bills from suppliers, so in this example, the business owes £250,000 to its suppliers. This arises because firms will be supplied goods from their suppliers and do not pay immediately (cash), but are given a bill and typically pay after 1 -2 months – Short-term loans are loans which need to be paid back within a year Current assets represents the finance they have, or will have over 12 months – Inventories means stocks ready to be sold, eg the clothes in a clothes store, so will be turned into cash – Trade receivables represents the money owed to them by customers who have bought goods, but have not yet paid for them Description Main categories £000 Non-current assets eg buildings 1,500 plusCurrent assets eg cash 600 minusCurrent liabilities eg payables 400 minusNon-current liabilities eg loans 700 Equals Net assets, which is the worth of the business 1,000 Current assets£000 Inventories (stocks) 200 Trade and other receivables 250 Cash 150 Total current assets 600 Current liabilities£000 Trade and other payables 250 Short-term loans 150 Total current liabilities 400

Measuring liquidity Current assets and liabilities In this example, the business will have to pay out £400,000 over the next 12 months Does it have enough short-term assets (finance) to pay these bills? – Current assets of £600,000 so perhaps Best way to decide is to compare current assets to current liabilities, using a ratio Called the current ratio and is current assets ÷ current liabilities, expressed as a ratio In this case 600 : 400, or 1.5 : 1, shortened to 1.5 Accountants believe an ideal ratio is 1.5 – Less than this means the firm may not have enough to pay bills and may become bankrupt – Too much higher and the firm may have too many resources tied up and not really being used Description Current assets £000 Inventories (stocks) 200 Trade and other receivables 250 Cash 150 Total current assets 600 Current liabilities £000 Trade and other payables 250 Short-term loans 150 Total current liabilities 400

Measuring liquidity Current assets and liabilities A low current ratio, eg 0.8 means a firm may not be able to pay bills Another ratio looks more carefully at a firm’s ability to pay bills by excluding inventories – This is because for many industries inventories may take time to turn into cash – May need to reduce prices to sell stock quickly, and some stock may be obsolete This is the acid test and is calculated as (current assets – inventories) ÷ current liabilities, again expressed as a ratio In this case (600 – 200) ÷ 400 Which is 1:1 or just 1 Ideal ratio is 1 Description Current assets £000 Inventories (stocks) 200 Trade and other receivables 250 Cash 150 Total current assets 600 Current liabilities £000 Trade and other payables 250 Short-term loans 150 Total current liabilities 400

Summary 2 ratios – Current ratio, which is current assets ÷ current liabilities – Acid test, which excludes inventories from current assets, so is (current assets – inventories) ÷ current liabilities – Ideal current ratio is 1.5, and ideal acid test is 1 – If the ratios are lower than this, then the business may have difficulty paying its bills – If a firm cannot pay bills it may in the worst case fail Suppliers will not supply, banks may ask for loans to be repaid Insufficient liquidity is the most common reason for a business to close