Download Liquidity-measuring

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
What is ‘liquidity’?
• Refers to the ability of a firm to find the cash to pay its bills
• Shows how vulnerable or resilient a company is to shortterm shocks
• To be ‘liquid’, money needs to be available to be used
quickly – either cash in a current account or an asset that
can easily be turned into cash to pay bills
• This availability of cash is compared to the known,
upcoming bills to assess ‘liquidity’
• This information is found on the ‘balance sheet’ or
‘statement of financial position’
Statement of financial position
(Balance Sheet)
Main categories
£000
Non-current assets eg buildings
1,500
plus
Current assets eg cash
600
minus
Current liabilities eg payables
400
minus
Non-current liabilities eg loans
700
Equals
Net assets, which is the worth of the business
1,000
• All PLCs must publish documents showing financial performance
including a ‘statement of financial position’, known as a ‘balance sheet’
• This records all the assets and liabilities of a business.
• Assets = what the firm owns
• Liabilities = what the firm owes / must pay or pay back
• Net assets = the value of the company
Main categories
£000
Current assets
Non-current assets eg buildings
1,500
Inventories (stocks)
200
£000
plus
Current assets eg cash
600
Trade and other receivables
250
minus
Current liabilities eg payables
400
Cash
150
minus
Non-current liabilities eg loans
700
Total current assets
600
Equals
Net assets, which is the worth of the
business
Current = ‘short term’
- in the next 12 months
1,000
Current liabilities
£000
Trade and other payables
250
Short-term loans
150
Total current liabilities
400
• Current assets = the finance they have, or expect to have in the next 12 months
– Inventories = stock ready to be sold (eg clothes in a clothes store – will be
turned into cash when sold)
– Trade receivables = money owed to them by customers who have bought goods
but have not yet paid for them (bought on credit)
• Current liabilities = bills which must be paid within 12 months
– Trade payables = bills from suppliers (eg. thi business owes £250,000 to its
suppliers. This firm must have received goods from their suppliers but did not
pay immediately (trade credit). This bill still must be paid.
– Short-term loans = loans which need to be paid back within the next 12 months
Measuring liquidity – current ratio
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
• This 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?
• Compare current assets to current
liabilities in a ratio – the ‘current ratio’
Current Ratio = 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; higher and the firm may have too many resources not being used
Measuring liquidity – acid test
Current liabilities
£000
Trade and other payables
250
Short-term loans
150
Total current liabilities
400
Current assets
£000
Inventories (stocks)
200
Trade and other receivables
250
Cash
150
Total current assets
600
• Another ratio looks more carefully at
a firm’s ability to pay bills by excluding
inventories
– inventories may take time to turn into
cash
– may need to reduce prices to sell
stock quickly, reducing their value &
contribution to paying bills
• This is the ‘acid test’ ratio
Acid test = (current assets – inventories) ÷ current liabilities (expressed as ratio)
In this case (600 – 200) ÷ 400 = 400:400
Which is 1:1 or shortened to ‘1’
Ideal ratio is 1
Liquidity ratios
Current Ratio
Current Assets : Current Liabilities
Acid Test
Liquid Assets : Current Liabilities
Statement of financial position
Non-current assets
Inventories
Receivables
Cash & cash equivalents
Total current assets
Current liabilities
Net current liabilities
Non-current liabilities
Net assets
£m
19550
2375
1170
2300
5845
(8160)
(2315)
(6000)
11235
Share capital
Reserves & retained earnings
Total equity
7000
4235
11235
Do you think this business has enough short
term assets to meet its short term debts?
Liquid assets has been calculated as:
Receivables + cash & cash equivalents.
Explain an alternative way of calculating
liquid assets.
Liquidity
What steps
could a
business take
to improve
cash flow?
What is the
relationship
between cash
flow and
liquidity?
• A business with low liquidity is in danger if short
term creditors demand payment quickly e.g. the
bank recalls an overdraft
• Business may seek to improve liquidity:
Increase current assets and/or reduce current
liabilities
• Sell assets that aren’t being used i.e. turn them from a
non-current assets to a current asset (cash)
• Switch to long term sources of finance – money doesn’t
have to be repaid so quickly
• Monitor debtors & tighten up on credit given to
customers
• Postpone investment plans
Working capital
• Another measure of liquidity / ability to meet day to day
expenses
• Working capital = current assets – current liabilities
• On the statement of financial position as ‘net current
liabilities’ or ‘net current assets’
• Working capital answers the question: If the firm had to
pay off all its short term debts could it do so out of its
short term resources i.e. inventories, payables and cash
• If not then it may have to sell non-current assets to pay
its debts and the business may cease trading
e.g. if a limousine hire business has to sell its limousines it
no longer has a business
Practice question
Using the extract
from SuperGroup
Plc’s statement of
financial position
calculate:
a) Current ratio
b) Acid test
c) Working capital
Comment on the
liquidity of
SuperGroup Plc.