IBBusiness ManagementHLRevision Notes3. Finance & Accounts3.5 Profitability & Liquidity Ratio AnalysisLiquidity Ratios

Liquidity Ratios (HL IB Business Management)

Revision Note

Flashcards
Lisa Eades

Ways to Measure Liquidity

  • Liquidity refers to the cash and other current assets businesses have available to quickly pay bills and meet short-term business/financial obligations
     
  • The liquidity of a business can be measured using two ratios, the current ratio and the acid test ratio

1. The Current Ratio

  • The Current Ratio is a quick way to measure liquidity and the outcome is expressed as a ratio
  • All of the current asset are included in calculating this ratio
  • The current ratio is an effective liquidity measure for businesses that hold little stock
  • The result indicates how many £s of current assets it has available to cover each £1 of short term debt
  • It is calculated using the formula

fraction numerator Current space assets over denominator Current space liabilities end fraction space space equals space ? space colon 1

Worked example

Packer Sports Ltd has current assets of £15,545, current liabilities of £5,060 and an inventory figure of £8,250.

Calculate Packer Sports Ltd’s current ratio. [2]

 

Step 1: Substitute the values into the equation

   £15,545 ÷ £5,060    =    3.07       [1 mark]

 

Step 2: Express the outcome as a ratio

   =    3.07: 1                [1 mark]

 
In this example, Packer Sports Ltd has £3.07 of current assets to cover each £1 of short-term debt

 
2. The Acid Test Ratio

  • The acid test ratio is a precise way to measure liquidity and is expressed as a ratio
  • The acid test ratio is also known as the liquid capital ratio
  • The least liquid form of current assets (stock) is deducted so the acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly
    • It may take some time to sell stock, so it is excluded
       
  • The acid test ratio is a particularly important measure of liquidity for businesses that hold a large amount of stock
  • It is calculated using the formula

fraction numerator space Current space assets space minus space stock over denominator Current space liabilities end fraction equals space space space space space ? space space space space space space colon space space space space space 1

Worked example

Packer Sports Ltd has current assets of £15,545, current liabilities of £5,060 and a stock figure of £8,250.

Calculate Packer Sports Ltd’s acid test ratio. [3]

 

Step 1: Subtract stock from current assets 

£15,545 - £8,250     =    £7,295              [1 mark]
 

Step 1: Substitute the values into the equation

£7,295 ÷ £5,060    =    1.44                  [1 mark]

 
Step 2: Express the outcome as a ratio

=    1.44: 1          [1 mark]
  

In this example, Packer Sports Ltd has £1.44 of the most liquid current assets to cover each £1 of short-term debt

Ways to Improve Liquidity

  • The best way to improve liquidity is to manage the business better
    • Use cash flow forecasts to identify potential cash flow issues before they arise - and take appropriate action
    • Budget effectively and consider adopting zero budgeting to carefully control spending
    • Set clear financial objectives and look for ways to reduce costs and increase income wherever possible
       

Methods to Improve Liquidity


Method


Explanation

Reduce the credit period offered to customers

  • Collecting money owed from customers more quickly will increase the level of current assets in the business
  • Customers may move to competing businesses that offer better credit terms

Ask suppliers for an extended repayment period e.g an extension from 60 to 90 days

  • Current liabilities will not be reduced
  • The business can use cash it would have paid to suppliers for other purposes
  • Suppliers may be unwilling to extend credit terms

Make use of Overdraft facilities or short-term loans

  • Current liabilities will increase
  • The business can spend more money than it has in its bank account
  • Banks may be reluctant to lend to businesses with cash-flow problems

Sell off excess stock

  • Less liquid current assets will be reduced and converted into more liquid forms of current asset (e.g. cash)
  • Storage and security costs may also be reduced
  • Stock may need to be sold at a low price to attract sales

Sell assets and lease fixed assets instead (e.g. sale and leaseback)

  • Both current assets and current liabilities will increase
  • The business will continue to have the use of assets but must make regular payments to the leasing company

Introduce new capital and reduce drawings out of the business

 

  • Current assets will be increased
  • New capital may be introduced by the owner or from additional investors
    • This may result in the dilution of control of the business

Exam Tip

You should always consider the appropriateness of methods you suggest to improve liquidity

Might your solutions solve a short-term cash flow problem - but cause greater issues in the longer term?

  • For example, would selling excess stock reduce the businesses ability to meet customer needs?

How might overall financial performance be affected?

  • For example, selling assets may worsen the balance sheet position

How likely is the solution capable of being achieved?

  • For example, are suppliers likely to provide trade credit?
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Lisa Eades

Author: Lisa Eades

Lisa has taught A Level, GCSE, BTEC and IBDP Business for over 20 years and is a senior Examiner for Edexcel. Lisa has been a successful Head of Department in Kent and has offered private Business tuition to students across the UK. Lisa loves to create imaginative and accessible resources which engage learners and build their passion for the subject.