methods of improving liquidity

10.2 Analysis of Published Accounts – Liquidity Ratios

Learning objective

Calculate, interpret and use the main liquidity ratios, recognise their limitations, and apply appropriate strategies to improve a business’s liquidity position in line with the Cambridge IGCSE/A‑Level Business syllabus (sections 5.3, 5.4‑5.5, 6‑10).

1. What is liquidity?

Liquidity is a company’s ability to meet its short‑term obligations as they fall due. It is measured by comparing liquid assets (those that can be turned into cash quickly) with current liabilities.

2. Key liquidity ratios

Ratio	Formula (syllabus wording)	What it measures	Indicative target range*
Current ratio	\(\displaystyle \frac{\text{Current assets}}{\text{Current liabilities}}\)	Overall ability to pay all current debts	1.5 – 2.0 (low 1.0, high 3.0)
Quick (acid‑test) ratio	\(\displaystyle \frac{\text{Current assets} - \text{Inventory}}{\text{Current liabilities}}\)	Ability to meet current debts without relying on inventory	0.8 – 1.2 (low 0.5, high 1.5)
Cash ratio	\(\displaystyle \frac{\text{Cash \& cash equivalents}}{\text{Current liabilities}}\)	Immediate cash available to settle current liabilities	0.5 – 0.8 (low 0.2, high 1.0)
Working‑capital ratio	\(\displaystyle \frac{\text{Working capital}}{\text{Total assets}}\) where Working capital = Current assets – Current liabilities	Proportion of total assets financed by net current resources	Varies by sector; often 0.10 – 0.30

*Indicative industry guidance – not required for the exam. Actual “good” levels depend on the firm’s sector, seasonality and risk profile.

3. Interpretation of the ratios

• Current ratio > 1 – more current assets than current liabilities; generally a sign of adequate liquidity.
• Quick ratio > 1 – can meet obligations without selling inventory; crucial for firms with slow‑moving stock.
• Cash ratio > 0.5 – a healthy cash buffer; especially important in volatile markets or where cash‑flow forecasts are uncertain.
• High ratios may indicate excess cash or inventory that could be invested elsewhere, while very low ratios signal potential solvency problems.
• Interpretation must consider:
  • Industry norms (e.g., utilities normally have lower ratios than retailers).
  • Stakeholder perspective – creditors focus on cash and quick ratios; shareholders are more interested in overall profitability.
  • Seasonality – a retailer’s current ratio may dip after a sales peak when inventory is high.

4. Limitations of liquidity ratios

• Snapshot nature: Ratios are based on a single balance‑sheet date and ignore timing of cash inflows/outflows.
• Seasonality: Seasonal businesses can show misleadingly low or high ratios at different points in the year.
• Industry differences: Capital‑intensive firms naturally have lower ratios.
• Balance‑sheet manipulation: Re‑classifying short‑term debt as long‑term can artificially improve ratios.
• Accounting policies: Different valuation methods for inventory (FIFO, LIFO, weighted average) or depreciation policies affect current‑asset values.
• Does not show profitability: A firm can be liquid but still lose money in the long run.

5. Cash‑flow forecasting (Syllabus 5.3)

A short‑term cash‑flow forecast provides the “future” dimension missing from ratio analysis. The three‑step process is:

1. Opening cash balance – cash on hand at the start of the period.
2. Cash inflows – collections from sales, loan proceeds, asset disposals, etc.
3. Cash outflows – payments to suppliers, wages, interest, tax, capital expenditure.

The forecast shows expected surplus or deficit for each month. By linking the forecast to ratio targets, students can demonstrate how a proposed action (e.g., speeding up receivables) will move the current, quick or cash ratio toward the desired range.

6. Budgets, variances & cost control (Syllabus 5.4‑5.5)

Operating budgets set the expected cash inflows and outflows; variance analysis highlights where reality diverges from the plan.

• Example of a variance impact:
  • Budgeted overheads = £50 k; actual overheads = £60 k (unfavourable variance of £10 k).
  • Assuming no change in other items, cash outflows rise by £10 k, reducing cash by the same amount.
  • Resulting cash‑ratio falls (e.g., from 0.55 to 0.45), signalling a liquidity problem that must be addressed.

7. Working‑capital management and the cash conversion cycle

The cash conversion cycle (CCC) links the three operating elements to liquidity.

CCC element	Typical action to improve liquidity	Ratio(s) most affected
Inventory days	Reduce stock levels (JIT, better forecasting, consignment)	Current ratio, Quick ratio (through lower inventory)
Receivables days	Accelerate collections (discounts, e‑invoicing, factoring)	Current ratio, Quick ratio, Cash ratio (more cash)
Payables days	Extend credit periods (without penalties)	Current ratio (liability side), Cash ratio (delayed cash outflow)

8. Methods of improving liquidity

Each method is linked to a specific part of the CCC and to one or more liquidity ratios.

8.1 Enhance cash management

• Prepare rolling 30‑day cash‑flow forecasts; update weekly.
• Use cash‑pooling or sweeping arrangements across subsidiaries to concentrate idle cash.
• Negotiate early‑payment discounts with suppliers (e.g., 2 % for payment within 10 days) and take advantage when cash is plentiful.

8.2 Accelerate receivables collection

• Offer modest cash‑discounts for prompt payment (e.g., “2 % discount if paid within 10 days, net 30”).
• Adopt electronic invoicing and automated reminder systems.
• Perform credit checks; set and regularly review credit limits.
• Use factoring or invoice discounting for immediate cash, bearing the service cost.

8.3 Reduce inventory levels

• Implement Just‑In‑Time (JIT) or lean inventory techniques.
• Improve demand forecasting using historical sales data and market trends.
• Enter consignment stock agreements – supplier retains ownership until sale.
• Review safety‑stock levels regularly to avoid excess.

8.4 Manage payables efficiently

• Negotiate longer credit periods (e.g., 60 days instead of 30 days) without incurring penalties.
• Take full advantage of the agreed credit period before paying; use “pay‑on‑date” scheduling.
• Treat trade credit as a low‑cost source of short‑term financing, but monitor supplier relationships.

8.5 Adjust short‑term financing

• Replace high‑interest overdrafts with lower‑cost revolving credit facilities.
• Issue short‑term commercial paper or secure a bank loan on favourable terms.
• Maintain an unused line of credit as a liquidity buffer for unexpected shortfalls.

8.6 Improve profitability (indirect effect)

• Raise sales margins through price optimisation or product differentiation.
• Control operating expenses – review overheads, utilities, staffing levels.
• Higher operating profit generates more cash from operations, boosting all liquidity ratios.

9. Integrating liquidity improvements into business planning

1. Analyse current‑ratio, quick‑ratio and cash‑ratio trends over the last three years.
2. Identify which ratio(s) fall outside the target range and the underlying cause (e.g., high inventory days).
3. Select actions from Section 8, prioritising those with the greatest cash impact and lowest risk.
4. Set SMART targets (e.g., “reduce inventory days from 90 to 60 within 12 months”).
5. Link actions to the cash‑flow forecast and operating budget; record the expected cash impact.
6. Monitor results quarterly; recalculate the ratios and compare with targets.
7. Adjust tactics as required – e.g., if receivables improve but payables become strained, renegotiate supplier terms.

10. Example 1 – Improving the Current Ratio (Retailer)

Situation: XYZ Ltd. reports a current ratio of 1.20 (Current assets £240 k; Current liabilities £200 k). Target = 1.50.

Action plan:

1. Accelerate receivables: Offer 2 % discount for payment within 10 days – expected cash inflow £30 k.
2. Reduce inventory: Adopt JIT, cutting inventory by £20 k.
3. Extend payables: Negotiate an extra 15 days with key suppliers – no immediate cash outflow.

Result after one month:

• Cash increases by £30 k.
• Inventory falls to £70 k.
• Current assets become £280 k; current liabilities remain £200 k.
• New current ratio = 1.40 – a step toward the 1.50 target.

11. Example 2 – Improving the Cash Ratio (Manufacturing firm)

Situation: Alpha Manufacturing reports a cash ratio of 0.30 (Cash & equivalents £15 k; Current liabilities £50 k). Target = 0.55.

Action plan:

1. Factoring: Sell £20 k of invoices at a 3 % fee, receiving £19.4 k cash immediately.
2. Delay non‑essential payables by 20 days, reducing cash outflows for the month by £5 k.
3. Sell obsolete stock for £8 k cash, removing the items from inventory.

Result after one month:

• Cash & equivalents rise to £42.4 k.
• Current liabilities remain £50 k.
• New cash ratio = 0.85 – comfortably above the target, providing a strong immediate liquidity buffer.

12. Exam tip – Using liquidity ratios in decision‑making

13. Connecting liquidity to the wider A‑Level Business syllabus

• External environment (Section 6) – interest‑rate movements and credit‑market conditions affect the cost and availability of short‑term finance.
• Business strategy (Section 7) – a cost‑leadership strategy often relies on tight working‑capital control to keep cash flowing.
• Human resources (Section 8) – workforce planning influences wage outflows, a major cash‑flow item.
• Marketing (Section 9) – pricing, promotion and credit terms directly affect sales margins and receivables.
• Operations (Section 10) – production methods such as JIT reduce inventory and improve the current and quick ratios.

When answering exam questions, always link your liquidity analysis back to these broader business areas where relevant.

14. Suggested diagram

Include a flowchart that shows the relationship between cash inflows, cash outflows and each liquidity‑improvement method, illustrating how changes to the cash conversion cycle affect the current, quick and cash ratios.