Liquidity (AQA A Level Business): Flashcards
Exam code: 7132
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- FrontWhat is Liquidity?
Define liquidity.
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Cards in this collection (27)
Define liquidity.
Liquidity is a business's ability to meet its short-term financial obligations as they fall due.
True or False?
A lack of liquidity is one of the most common reasons businesses fail.
True.
Many businesses fail not because they are unprofitable, but because they run out of cash at the wrong moment.
Liquidity is fundamentally about ____, as a business must have cash available when its bills are due.
Liquidity is fundamentally about timing, as a business must have cash available when its bills are due.
Define receivables.
Receivables are amounts owed to the business by customers who have already received goods or services but have not yet paid for them.
Why can receivables cause cash flow problems for a profitable business?
Receivables are revenue that has been earned but not yet received as cash. This creates a gap between when profit is recorded and when money actually arrives.
Define receivables days.
Receivables days measures the average number of days it takes a business to collect money from its debtors.
Receivables days = Receivables ÷ Sales revenue × 365
True or False?
A rising receivables days ratio shows that a business is becoming more efficient at collecting its debts.
False.
Businesses aim for a low or reducing receivables days ratio. A rising ratio means customers are taking longer to pay, which puts greater strain on cash flow.
What further action can a business take if customers still fail to pay their invoices on time?
It can refuse to provide further goods until outstanding debts are paid or threaten legal action, such as through the Small Claims Court. These methods may damage relationships with customers.
Define payables.
Payables are amounts owed by the business to its suppliers for goods or services it has already received but not yet paid for.
Payables are effectively a short-term, ___________ source of finance, as the business uses goods or services now and pays for them later.
Payables are effectively a short-term, interest-free source of finance, as the business uses goods or services now and pays for them later.
True or False?
High payables are always a sign of strong cash management.
False.
High payables can be a warning sign if they result from the business being unable to pay, rather than choosing to delay payment strategically.
Define payables days.
Payables days measures the average number of days a business takes to pay invoices owed to its creditors.
Payables days = Payables × 365 ÷ Cost of sales
What might a high or increasing payables days ratio indicate?
It may indicate effective negotiation skills in arranging extended credit terms with suppliers.
Why can paying suppliers later than agreed harm a business?
It can worsen the business's creditworthiness. The business may fail credit checks, find it harder to obtain trade credit elsewhere and struggle with applications for borrowing such as loans.
Define current ratio.
The current ratio measures liquidity using all current assets, showing how many £s of current assets are available to cover each £1 of short-term debt.
Current ratio = Current assets ÷ Current liabilities
For which type of business is the current ratio an especially effective liquidity measure?
The current ratio is especially effective for businesses that hold little inventory.
A business has current assets of £15,545 and current liabilities of £5,060. What is its current ratio?
The current ratio is 3.07 : 1. The business has £3.07 of current assets to cover each £1 of short-term debt.
Define acid test ratio.
The acid test ratio is a more precise measure of liquidity that deducts stock from current assets, giving a more realistic view of the business's ability to meet short-term debts quickly.
Acid test = (Current assets − Stock) ÷ Current liabilities
Stock is deducted in the acid test because it is the __________ form of current asset and may take some time to sell.
Stock is deducted in the acid test because it is the least liquid form of current asset and may take some time to sell.
True or False?
For a business that holds stock, the acid test ratio is lower than the current ratio.
True.
The acid test deducts stock from current assets, so it is lower than the current ratio for any business that holds stock.
What does the gap between the current ratio and the acid test ratio reveal?
The gap reveals how dependent a business is on its stock to maintain liquidity.
What is the best overall way for a business to improve its liquidity?
The best way is to manage the business better. This includes using cash flow forecasts to spot problems early, budgeting effectively and setting clear financial objectives.
How does selling off excess stock improve liquidity?
It converts less liquid current assets into more liquid forms, such as cash, and may reduce storage and security costs. However, the stock may need to be sold at a low price.
True or False?
Asking suppliers for an extended repayment period reduces a business's current liabilities.
False.
Current liabilities will not be reduced. However, the business can use the cash it would have paid to suppliers for other purposes.
What is the main drawback of reducing the credit period offered to customers?
Customers may move to competing businesses that offer better credit terms.
What happens to current liabilities when a business uses an overdraft to improve liquidity?
Current liabilities increase, although 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.
What is a drawback of introducing new capital from additional investors?
Bringing in additional investors may result in the dilution of control of the business.
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