Liquidity ratios - introduction AO2, AO4
AO2 You need to be able to: Demonstrate application and analysis of knowledge and understanding Command Terms: These terms require students to use their knowledge and skills to break down ideas into simpler parts and to see how the parts relate: Analyse, Apply, Comment, Demonstrate, Distinguish, Explain, Interpret, Suggest
AO4 You need to be able to Demonstrate a variety of appropriate skills. Command Terms These terms require you to demonstrate the selection and use of subject-specific skills and techniques: Annotate, Calculate, Complete, Construct, Determine, Draw, Identify, Label, Plot, Prepare
Liquidity ratios are concerned with the short term financial health of the business and whether the working capital of the business is being managed effectively. Too little working capital and the firm may not be able to pay all of its debts (even though it is making profits on paper), and ultimately this may result in closure. Too much working capital and the business may not be making the most efficient use of its financial resources for expansion.
Liquidity refers to whether the firm has the current assets with which it can pay its bills (current liabilities). Normally these current assets are in the form of cash and bank accounts. A firm is liquid if it can pay its bills ok.
There is little liquidity information in the profit and loss account, but the balance sheet is more valuable. Liquidity is a short-term matter and can change very quickly, so it is always worth remembering that the balance sheet is simply a snapshot at a particular time.
Now, let's look at the balance sheet. The firm will have to meet its liabilities some time, but the current liabilities are the most important.
These are people, firms and organisations to which the firm owes money. Some are more important than others. The critical creditors are probably the tax authorities (which collect company tax, employees income tax and sales tax) and the banks. Payments are due on a set day, and failure to pay may lead to the closure of the firm.
These are short-term borrowings from banks. Firms often use this as a means to make up for working capital shortages. They generally have to be cleared within 6 months or asap.
If these are from banks they have to be paid. If the firm is reliable enough it may be able to re-organise an overdraft or short-term loan into a long-term loan.
On the other hand, the firm has its current assets to help it pay its bills. A reminder that current assets are:
Clearly very useful for paying bills as it is the most liquid of funds.
These are people or organisations, who owe the firm money. They should pay within the present financial year, depending on the credit terms given by the firm (often 30 days). They can be turned into cash quickly if it is necessary. The bills can be factored, that is sold to a firm, which will collect the revenue when they become due. Obviously, factoring companies will only pay a percentage of the value of the debts. Debtors are relatively liquid compared to other assets, but are not as good as cash.
These are assets of the firm and can, theoretically, be sold to raise cash. In reality, however, this may not always be the case. They may be out of season, unfashionable or even obsolete. They may not even be finished goods. Other firms or customers may not want them, and even if they do, only at a relatively low price. Stocks are considered to be the least liquid of the current assets.
There are two liquidity ratios:
- Current ratio
- Acid test ratio