2.3.2 Liquidity Flashcards
(15 cards)
What is the definition of liquidity?
Liquidity refers to how quickly assets can be converted into cash to pay its current liabilities
What is the purpose of the statement of financial position?
To provide a snapshot valuation of the business, including what it owes, what it owns, and owner equity
=balance sheet
What are current assets (CA)?
Items the business owns that will become cash within one year, e.g., stock or debtors
What are current liabilities (CL)?
Items the business owes to others that must be paid within one year, e.g., trade creditors, Short-term loans and overdrafts, Current portion of long-term debt (due within a year)
What is the current ratio formula?
Current assets / Current liabilities
What is the acid test ratio formula?
(Current assets - Inventory) / Current liabilities
True or False: The acid test ratio is also known as the quick ratio.
True
What does an acid test ratio of less than 1:1 indicate?
Current assets (minus stocks) do not cover current liabilities
List ways to improve liquidity.
- Reduce the amount of stocks held
- Reduce the credit period offered to customers
- Pay suppliers later on agreed credit terms
- Increase long-term borrowing to clear short-term debts
What is working capital?
Day-to-day finance needed to trade in a business, calculated as Current Assets minus Current Liabilities (CA - CL)
Why is cash important for a business?
It is the finance available for the business to meet its short-term debts
How can a business improve its working capital cycle?
By reducing the time cash is tied up in stock or owed by debtors
What is the significance of liquidity for business owners and investors?
✅ High liquidity ➔ business can easily pay bills ➔ avoids debt and cash flow problems ➔ reduces risk of failure.
✅ High liquidity ➔ stronger financial health ➔ banks and suppliers trust the business more ➔ easier to get credit or loans.
✅ High liquidity ➔ can react quickly ➔ able to grab opportunities (like buying cheap stock or expanding fast).
Fill in the blank: The acid test ratio is a harsher test of liquidity because it excludes _______.
[Stock]
What is the working capital cycle?
The time it takes for cash to be tied up in stock or owed by debtors before it is available again
