F4 - Measuring liquidity

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6 Terms

1
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What is liquidity?

  • A measure of a business’s ability to survive in the short term i.e. its ability to meet short term dets and day to day expenses.

  • If a business cannot meet current liabilities from current assets then it is at risk of failure if creditors demand immediate payment of debts.

2
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How is Current ratio calculated?

  • Current assets / current liabilities

  • CA / CL

<ul><li><p><strong><mark>Current assets / current liabilities </mark></strong></p></li></ul><p></p><ul><li><p><strong><mark>CA / CL </mark></strong></p></li></ul><p></p>
3
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How is the Liquid capital ratio calculated?

  • Current assets - inventories / current liabilities

  • CA - INV / CL

4
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Why is the Liquid capital ratio a tougher measure of solvency?

  • The liquid capital ratio is a tougher measure of solvency as it excludes inventory.

  • This is because stock is thought to be the hardest of the current assets to turn into cash quickly.

<ul><li><p>The liquid capital ratio is a tougher measure of solvency as it <strong><mark>excludes inventory. </mark></strong></p></li><li><p>This is because <strong><mark>stock is thought to be the hardest of the current assets to turn into cash quickly. </mark></strong></p></li></ul><p></p>
5
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How can a business with low liquidity be in danger?

  • A business with low liquidity is in danger if short term creditors demand payment quickly e.g. the bank recalls an overdraft.

6
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How can businesses improve liquidity?

  • Sell assets that are no longer being used e.g. turn them from a non-current asset to a current asset (cash).

  • Move cash balances from current accounts to high interest bearing accounts so its value increases more rapidly - ISA.

  • Switch to long term sources of finance.

  • Monitor debtors to avoid bad debts.