Liquidity (Edexcel IGCSE Business)

• Liquidity is defined as the ability of a business to pay back its short-term debts, e.g. its suppliers
  
  
• A businesses that cannot pay its debts is considered insolvent
  • If a business cannot pay its suppliers, raw materials or components may not be delivered and production will be delayed
  • If it cannot repay an overdraft, banking facilities may be withdrawn, and its credit rating will suffer
  • Creditors may force it to stop trading and sell its assets so that the debts owed to them are repaid
    
    
• Stakeholders interested in liquidity include
  • Suppliers want to be reassured that a business is likely to be able to pay for them
  • Financial providers such as banks want evidence that a business is likely to be able to repay loans or overdrafts
  • Customers want to be sure that a supplier will be able to produce and deliver goods it orders

The liquidity of a business can be measured using two ratios

• • Current ratio
  • Acid test ratio
    
    

The Current Ratio

• The Current Ratio is a quick way to measure liquidity
  • The outcome is expressed as a ratio
  • All types of current asset are included in calculating this ratio
  • The result indicates how many £s (or other currency units) of current assets are available to cover each £1 (or other currency unit) of short-term debt
  • It is calculated using the formula

The Acid Test Ratio

• The acid test ratio is a precise and realistic way to measure liquidity, especially for businesses that hold large amounts of inventory
  • It is expressed as a ratio
  • It is also known as the liquid capital ratio
  • The least liquid form of current assets (inventory) is deducted so the acid test ratio provides a more realistic measure of the businesses ability to meet short-term debts quickly
    • It often takes time to sell inventory so it is excluded
       
  • The Acid Test is calculated using the formula
    
    

Comparing Liquidity

Businesses compare and monitor liquidity over time

• • A business may be able to identify a pattern of periods of good and poor liquidity
    • For some businesses poor liquidity can be seasonal
      • E.g. Low sales often follow major public holidays such as Christmas
        
        
    • Steps can be taken to improve the liquidity position at these times
      • E.g. Short-term finance such as overdrafts can be arranged
         

The impact on liquidity of spending decisions can be determined

• • Budgets that ensure a healthy liquidity position can be set
  • Capital expenditure could be delayed to avoid liquidity problems
     

Comparing liquidity between different businesses is problematic

• • Some businesses can survive on very low ratios
    • Businesses that have a high level of inventory turnover and sell for cash can have very low liquidity ratios
      • In 2023 Tesco Plc, the UK's largest supermarket, had a current ratio was just 0.71:1
        
        
    • Businesses that sell small volumes of expensive products, often on credit, require much higher liquidity ratios
      • In 2023 LVMH Group, owner of brands including Louis Vuitton and Acqua di Parma, had a current ration of 4.34:1

Improving Liquidity

• A business will often need to take quick, decisive steps to improve their liquidity

Diagram: Ways to Improve Liquidity

Liquidity can be improved in a number of ways
 

Methods to Improve Liquidity