2.3.2 Liquidity

What is the Statement of Financial Position?

A financial document showing a business’s assets, liabilities, and capital at a specific point in time, e.g. balance sheet

What does the Statement of Financial Position help assess?

It helps assess the liquidity and financial structure of a business.

What is liquidity?

Liquidity is a measure of how easily a business can pay its short-term debts (current liabilities) using its current assets.

Why is liquidity important?

A business may fail quickly if it cannot pay its short-term debts — even if it is profitable.

How does managing liquidity help a business?

It helps a business manage risk and prepare for the unexpected.

What are the two main ratios used to measure liquidity?

The Current Ratio and the Acid Test Ratio.

Define assets and liabilities

• Assets = What the business owns - cash, stock equipment, money customers will pay you

• Liabilities = What the business owes - rent, bills or loan repayments

Define current assets, give examples

Assets the business expects to turn into cash within 12 months.

Examples:

• Cash 💰

• Inventory (stock) 📦

• Receivables / trade debtors (money customers owe) 🧾

• Short-term investments

Define non-current assets, give examples

Assets the business will use for more than a year. Also called fixed assets.

Examples:

• Property and buildings 🏢

• Machinery and equipment ⚙

• Vehicles 🚚

• Long-term investments

Define current liabilities, give examples

Debts the business needs to pay within 12 months.

Examples:

• Overdrafts 🏦

• Trade payables / creditors (money owed to suppliers) 🧾

• Short-term loans

• Taxes owed to HMRC

Define non-current liabilities, give examples

Debts the business will pay back over more than a year.

Examples:

• Bank loans (long-term)

• Mortgages

• Pension obligations

What is the Current Ratio formula?

Current Ratio= Current Assets​ / Current Liabilities

What does the Current Ratio show?

The current ratio is a calculation that shows how many times a business can pay off its current liabilities using its current assets.

What is the Acid Test Ratio formula?

Acid Test Ratio= Current Assets - Inventory​ / Current Liabilities

Why is the Acid Test Ratio more realistic?

It removes inventory, the least liquid current asset, giving a clearer picture of a business’s immediate ability to pay debts.

How can a business improve liquidity?

By managing better through:

• Cash flow forecasts

• Budgeting (e.g. zero-based budgeting)

• Reducing costs or increasing income

What are 5 ways a business can improve liquidity?

• Reduce credit period for customers - collecting money owed from customers more quickly will increase the level of current assets in the business

• Ask suppliers for longer to pay

• Use overdrafts or short-term loans

• Sell excess stock

• Sell assets and lease them back

What is working capital?

The money available for day-to-day activities, also known as net current assets.

What is the formula for working capital?

Working Capital= Current Assets−Current Liabilities

Why is working capital called the "lifeblood" of a business?

Without it, the business can’t meet immediate financial obligations and may fail, even if it's profitable.

What assets are most and least liquid?

• Most liquid: Cash

• Less liquid: Debtors and inventory

How can a business increase working capital quickly?

• Chase up debtors

• Sell stock (even at lower prices)

• Request longer payment terms from suppliers

• Use short-term borrowing (e.g. overdraft)

Can a business have too much working capital?

Yes — cash sitting idle could be better invested, and holding too much stock increases storage and opportunity costs.