CHAPTER 35: LIQUIDITY
I. Distinction between profit & cash
Profit - money that the business has after all costs have been subtracted from
sales revenue.
Cash - any asset of the business that can be converted into cash for day-to-day
transactions. e.g., cheque should be converted into cash to be used by the
business. Also, an asset of the business that can be used immediately for any
transactions of the business. e.g., notes
II. Statement of Financial Position (Balance Sheet)
A summary at a particular point in time of the value of a firm’s assets,
liabilities & capital.
Assets - resources owned by the business. Business use assets to make
products/provide services. e.g., buildings, vehicles, equipment, etc.
Liabilities - money owed by the business to banks & suppliers, for
example.
Capital - money put into the business by the owners.
Components of a Balance Sheet:
1. Non-current Assets (fixed assets)
long-term resources that will be used by the business over a period of time. e.g.,
land, property, plant, equipment, tools, vehicles & fixture & fittings.
Also includes intangible assets (non-physical assets) such as brand names &
patents.
2. Current assets (liquid assets)
assets that will be changed into cash within 12 months. e.g., inventories, trade
other receivables (debtors & prepayments), cash/cash equivalents.
3. Current liabilities
any money owed by a business that must be repaid within one year. e.g., Loan &
other borrowings, trade & other payables, current tax liabilities.
4. Non-current liabilities
money owed by the business for more than one year, sometimes called long-term
liabilities. e.g., long-term bank loans, mortgages, pensions
5. Net assets
𝑁𝑒𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
equals to shareholder’s equity at the bottom of Statement of Financial Position.
6. Shareholder’s equity
the amount owed by the business to the shareholders. e.g., share capital, retained
profit
CHAPTER 35: LIQUIDITY
Example of a Statement of Financial Position
In some financial statements, figures may be shown in brackets. This just means that they are
negative/ should be subtracted.
III. Measuring Liquidity
How much liquid assets the business has to meet its debts/ borrowings.
1. Current ratio
assesses whether a business has enough resources to meet any debts that
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 / 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
arise in the next 12 months.
2. Acid test ratio
similar to the current ratio but excludes stocks from current assets. A more
𝐴𝑐𝑖𝑑 𝑡𝑒𝑠𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 – 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒s / current
severe test of liquidity.
liabilities
CHAPTER 35: LIQUIDITY
IV. Ways to improve liquidity
Measures which can be used to either generate cash or save it
1. Use of overdraft facilities.
A business can increase its cash by borrowing more money on its overdraft. But
there may be a problem if it is already up to its overdraft limit then it has to
negotiate with its bank. Banks will usually not lend money to businesses that is
experiencing cash flow problems & could cease trading in the immediate future.
2. Negotiate short term/long term loans
A business may be able to obtain short-term loan from a bank to inject some extra
cash.
3. Encourage cash sales
To increase cash, business will offer discount for those customers who will pay
early through cash. So, people will buy beforehand due to discount, this will
increase cash for the business.
4. Sell off stocks
Business can sell its stocks of raw material, semi-finished goods & finished goods
to generate more cash into the business.
5. Sale
Business can sell its assets to generate cash into the business.
6. Only make essential purchases
During cash crises business should postpone/cancel all unnecessary spending.
Business should only buy resources for cash when it absolutely must.
V. Working capital
CHAPTER 35: LIQUIDITY
Also known as circulating capital.
The funds left over to meet day to day expenses after current debts have been
paid. It is calculated by subtracting current liabilities from current assets.