The liquidity of assets and insolvency

Liquidity refers to how quickly an asset can be converted into cash for spending.

Levels of liquidity in different assets

• Cash - Highly liquid, as it can be used immediately for purchases or payments.
• Inventory (stock) - Moderately liquid, since it needs to be sold before turning into cash.
• Money owed by debtors (receivables) - Also moderately liquid, depending on how quickly customers pay their debts.
• Non-current assets - Low liquidity, such as factories or machinery, which are difficult to sell quickly.

A business becomes insolvent if it lacks sufficient current assets to cover liabilities when they fall due. Insolvent firms may seek quick funding, negotiate extended payment terms with creditors, or enter liquidation as a last resort.

Ways to improve liquidity

• Reduce inventory levels to free up cash tied in unsold goods.
• Accelerate the collection of debts from customers.
• Delay payments to suppliers where possible, without damaging relationships.

Liquidity ratios

Liquidity ratios assess a business's ability to pay short-term debts using its current assets. The two primary ratios are the current ratio and the acid test ratio.

Current ratio

The current ratio compares current assets to current liabilities.

$\text{Current ratio}=\frac{\text{current assets}}{\text{current liabilities}}$

Where:

• Current assets = Items like cash, inventory, and receivables (£)
• Current liabilities = Short-term debts like payables and overdrafts (£)

An ideal current ratio ranges from 1.5 to 2. A value below 1.5 signals potential liquidity issues, while a much higher value suggests excess assets that could be reinvested for better returns. However, a high ratio might indicate the business is not prioritising profit maximisation.

Acid test ratio

The acid test ratio is a stricter measure, excluding inventory to focus on more liquid assets.

$\text{Acid test ratio}=\frac{\text{current assets}-\text{inventory}}{\text{current liabilities}}$

Where:

• Current assets - inventory = Highly liquid items like cash and receivables (£)
• Current liabilities = Short-term debts (£)

Most businesses aim for an acid test ratio above 1 to ensure they can meet obligations without relying on selling stock. Firms with rapid inventory turnover, such as supermarkets, may operate with lower ratios successfully. A high ratio could mean idle cash that should be used more productively.

Worked example - Calculating liquidity ratios

A business has current assets of £55,000 (including £12,000 in inventory) and current liabilities of £30,000. Calculate the current ratio and acid test ratio.

Step 1: Identify the values

• Current assets = £55,000
• Inventory = £12,000
• Current liabilities = £30,000

Step 2: Calculate the current ratio

$\text{Current ratio}=\frac{\pounds \mathrm{55,000}}{\pounds \mathrm{30,000}}\approx 1.83$

Step 3: Calculate the acid test ratio

$\text{Acid test ratio}=\frac{\pounds \mathrm{55,000}-\pounds \mathrm{12,000}}{\pounds \mathrm{30,000}}=\frac{\pounds \mathrm{43,000}}{\pounds \mathrm{30,000}}\approx 1.43$

Working capital

Working capital represents the funds available for everyday operations, ensuring a business can cover short-term debts.

$\text{Working capital}=\text{current assets}-\text{current liabilities}$

Where:

• Current assets = Cash, inventory, and receivables (£)
• Current liabilities = Short-term debts (£)

Higher working capital indicates greater liquidity. Insufficient working capital can lead to survival challenges. It is also known as net current assets.

Worked example - Calculating working capital

A firm has current assets worth £75,000 and current liabilities of £40,000. Calculate the working capital.

Step 1: Identify the values

• Current assets = £75,000
• Current liabilities = £40,000

Step 2: Apply the formula

$\text{Working capital}=\pounds \mathrm{75,000}-\pounds \mathrm{40,000}=\pounds \mathrm{35,000}$

The working capital cycle

The working capital cycle measures the time from purchasing raw materials to receiving cash from sales, typically in days.

Factors influencing the working capital cycle

• Product nature - Complex items with long production times or extended storage periods lengthen the cycle.
• Credit terms - Offering customers 30 days to pay extends the cycle compared to requiring payment within 7 days.
• Supplier terms - Longer payment periods from suppliers can shorten the cycle by delaying outflows.

Factors affecting cash requirements

Businesses require enough cash to meet short-term obligations, but excess cash represents missed opportunities for investment.

Key factors influencing cash needs

• Length of working capital cycle - Longer cycles demand more cash to bridge gaps between payments and receipts.
• Inflation - Rising prices increase costs for wages and inventory, necessitating additional cash reserves.
• Business growth - Expansion requires extra cash to support higher production and avoid overtrading.
• Overtrading - This happens when a business increases output beyond its capacity to pay suppliers before customer payments arrive, leading to cash shortages despite sales growth.