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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.