concept of liquidity

5.5.2 Liquidity – Understanding the Concept (Cambridge IGCSE Business Studies)

1. What is Liquidity?

• Liquidity is a business’s ability to meet its short‑term financial obligations as they fall due.
• In practice it shows how quickly and easily a company can convert assets into cash without a material loss of value.

2. Why Liquidity Matters

• Ensures timely payment of suppliers, wages, tax and other operating costs.
• Reduces the need to borrow at high interest rates and lowers the risk of insolvency.
• Builds confidence among investors, lenders and other stakeholders.
• Provides the flexibility to seize unexpected opportunities (e.g., bulk‑buy discounts).

3. Working‑Capital Concept

• Working capital (value) = Current assets – Current liabilities (a £‑amount).
• Shows the amount of short‑term resources that remain after all current liabilities have been covered.
• Do not confuse this with the working‑capital ratio (the current ratio); the former is a monetary value, the latter a ratio.

4. Reading a Simple Statement of Financial Position (Balance Sheet)

A balance sheet lists a business’s assets and liabilities at a point in time. For liquidity we focus on the **current** part:

Current Assets	Examples
Cash and cash equivalents	Bank balances, petty cash
Trade receivables	Money owed by customers
Inventory	Raw materials, work‑in‑progress, finished goods
Pre‑paid expenses	Insurance paid in advance

Current Liabilities	Examples
Trade payables	Money owed to suppliers
Short‑term borrowings	Bank overdrafts, short‑term loans
Accrued expenses	Wages, tax payable

5. Cash‑Flow Forecasting (Brief Overview – AO2)

• Predicts the amount of cash that will flow into and out of the business over a future period (usually 12 months).
• Key steps:
  1. Estimate cash inflows – sales receipts, loan proceeds, asset sales.
  2. Estimate cash outflows – payments to suppliers, wages, tax, interest, capital expenditure.
  3. Calculate the net cash flow for each month and the closing cash balance.
• Helps managers anticipate periods of low liquidity and take corrective action (e.g., arrange a line of credit).

6. Liquidity Ratios (Cambridge Syllabus)

6.1 Current Ratio

Compares all current assets with current liabilities.

$$\text{Current Ratio} = \frac{\text{Current Assets}}{\text{Current Liabilities}}$$

A ratio > 1 indicates that current assets exceed current liabilities.

6.2 Quick Ratio (Acid‑Test Ratio)

Excludes inventory because it may not be quickly convertible to cash.

$$\text{Quick Ratio} = \frac{\text{Current Assets} - \text{Inventory}}{\text{Current Liabilities}}$$

A quick ratio of 1 or higher is generally regarded as satisfactory.

6.3 Cash Ratio (Optional – not listed in the syllabus but useful for deeper analysis)

Measures the ability to meet current liabilities using only cash and cash equivalents.

$$\text{Cash Ratio} = \frac{\text{Cash \& Cash Equivalents}}{\text{Current Liabilities}}$$

6.4 Working Capital (Value)

$$\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}$$

7. Profitability Ratios (Required by the syllabus – AO1)

Although the focus of this section is liquidity, the Cambridge syllabus expects students to know the main profitability ratios and when they are used.

Ratio	Formula	Interpretation
Gross Profit Margin	$$\frac{\text{Gross Profit}}{\text{Sales}} \times 100$$	Shows what proportion of sales is left after deducting the cost of goods sold.
Profit Margin	$$\frac{\text{Net Profit}}{\text{Sales}} \times 100$$	Indicates overall efficiency in converting sales into profit.
Return on Capital Employed (ROCE)	$$\frac{\text{Operating Profit}}{\text{Total Assets} - \text{Current Liabilities}} \times 100$$	Measures how well a business uses its long‑term capital to generate profit.

8. Interpretation of Ratios – Who Uses Them? (AO3)

• Managers – monitor day‑to‑day cash needs, decide on credit terms, plan inventory levels.
• Bankers / Lenders – assess risk before granting loans (e.g., current ratio, quick ratio).
• Investors – evaluate the short‑term safety of their investment and the firm’s ability to fund growth.
• Suppliers – decide whether to offer trade credit.

9. Limitations of Liquidity Ratios

• Ratios are static snapshots; they do not show the timing of cash inflows and outflows.
• Seasonal businesses may appear ill‑liquid in off‑peak periods even though they are financially sound.
• Inventory quality varies; a high current ratio can be misleading if much of the inventory is obsolete.
• Quick and cash ratios ignore the collectability of receivables that may be difficult to recover.
• Ratios do not reflect external factors such as interest‑rate changes, inflation, or economic downturns.

10. Liquidity, Solvency and Cash‑Flow Forecasting (AO4)

• Liquidity – short‑term ability to meet debts as they fall due.
• Solvency – long‑term ability to meet all debts (including long‑term loans).
• A business can be liquid (good current ratios) but still be insolvent if long‑term liabilities exceed total assets.
• Cash‑flow forecasting helps managers anticipate periods of low liquidity and plan corrective actions (e.g., arranging a line of credit).

11. External Influences on Liquidity (Context Box – AO3/4)

Liquidity decisions are affected by the wider economic environment:

• Interest‑rate changes – Higher rates increase borrowing costs, making strong liquidity more critical.
• Inflation – Erodes the real value of cash reserves; firms may hold less cash and invest in short‑term instruments.
• Economic cycle – Recessions tighten credit and reduce customer payments, pressuring liquidity.
• Exchange‑rate fluctuations – For import‑dependent businesses, a weaker domestic currency can increase the cash needed for purchases.

12. Factors That Can Affect Liquidity

• Seasonal fluctuations in sales and cash inflows.
• Credit terms offered to customers – longer terms delay cash receipts.
• Inventory management – excess or slow‑moving stock ties up cash.
• Unexpected expenses or emergencies (e.g., equipment breakdown).
• External influences listed above.

13. Improving Liquidity (Actions & Justification)

1. Accelerate cash collections – tighten credit terms, offer early‑payment discounts, use factoring.
2. Reduce inventory levels – adopt just‑in‑time ordering, improve stock turnover.
3. Negotiate longer payment periods with suppliers – improves cash‑outflow timing.
4. Maintain a cash reserve or line of credit – provides a safety net for unforeseen cash shortages.
5. Review pricing and discount policies – ensure they do not erode cash margins.

14. Example Calculations (Liquidity & Profitability)

Balance‑sheet excerpt for XYZ Ltd (all figures in £):

Item	Amount
Cash and bank	25,000
Accounts receivable	40,000
Inventory	35,000
Pre‑paid expenses	5,000
Current liabilities	60,000

1. Current Assets = 25,000 + 40,000 + 35,000 + 5,000 = £105,000
2. Current Ratio = 105,000 ÷ 60,000 = 1.75
3. Quick Ratio = (105,000 – 35,000) ÷ 60,000 = 70,000 ÷ 60,000 = 1.17
4. Cash Ratio = 25,000 ÷ 60,000 = 0.42
5. Working Capital = 105,000 – 60,000 = £45,000

Profit‑and‑Loss excerpt for XYZ Ltd (all figures in £):

Item	Amount
Sales (Revenue)	200,000
Cost of Goods Sold	120,000
Gross Profit	80,000
Operating expenses	30,000
Net Profit	50,000
Operating Profit (for ROCE)	70,000

6. Gross Profit Margin = (80,000 ÷ 200,000) × 100 = 40 %
7. Profit Margin = (50,000 ÷ 200,000) × 100 = 25 %
8. ROCE = (70,000 ÷ (Total Assets – Current Liabilities)) × 100
   Assume total assets = £180,000. ROCE = (70,000 ÷ (180,000 – 60,000)) × 100 = (70,000 ÷ 120,000) × 100 = 58.3 %

15. Interpreting the Results (AO3)

• Current Ratio = 1.75 – For every £1 of current liabilities, XYZ Ltd has £1.75 of current assets; a comfortable short‑term position.
• Quick Ratio = 1.17 – Even without selling inventory, the firm can meet its short‑term debts.
• Cash Ratio = 0.42 – Cash alone covers only 42 % of current liabilities; the business relies on receivables and inventory.
• Working Capital = £45,000 – Positive working capital confirms that short‑term resources exceed short‑term obligations.
• Gross Profit Margin = 40 % – Indicates a healthy markup on sales.
• Profit Margin = 25 % – Shows that a quarter of sales is retained as profit after all expenses.
• ROCE = 58.3 % – Very strong return on the capital employed, attractive to investors.
• Because the quick and cash ratios are lower than the current ratio, the business should monitor the collectability of receivables and the turnover of inventory.

16. Interpretation Exercise (AO3 – Test Your Understanding)

Below is a mini statement of financial position for ABC Co.

Current Assets	£
Cash	12,000
Accounts receivable	18,000
Inventory	20,000
Pre‑paid expenses	5,000
Total Current Assets	55,000

Current Liabilities	£
Trade payables	30,000
Bank overdraft	10,000
Accrued expenses	5,000
Total Current Liabilities	45,000

Task: Calculate the current ratio, quick ratio and working capital. Then write a brief paragraph (2‑3 sentences) stating whether ABC Co. is liquid, why, and what this means for a bank considering a loan.

17. Quick Revision Checklist

• Definition and importance of liquidity.
• Difference between working capital (value) and working‑capital ratio (current ratio).
• How to read a simple statement of financial position – identify current assets and liabilities.
• Key liquidity formulas: current ratio, quick ratio, cash ratio (optional), working capital.
• Profitability ratios required by the syllabus: gross profit margin, profit margin, ROCE.
• How to calculate and interpret each ratio.
• Limitations of liquidity ratios.
• Relationship between liquidity, solvency and cash‑flow forecasting.
• External influences that affect liquidity decisions (interest rates, inflation, economic cycle, exchange rates).
• Factors that can affect liquidity internally (seasonality, credit terms, inventory, unexpected expenses).
• Practical actions a manager can take to improve liquidity and the rationale behind each.
• Who uses each ratio and why (managers, banks, investors, suppliers).
• Interpretation exercise – apply knowledge to a mini‑balance sheet.