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“Everyone welcome to this business topic video. Which is going to provide an overview an an introduction to the important topic of liquidity ratios let s just first of all what a liquidity ratio is compared with all the other financial and other ratios that you may have come across such as profitability or efficiency ratios. Liquidity is really all about the ability of the business develop a amount that it owes. When there s you so does it have the cash or other assets that enables it to pay its current liabilities.
Liquidity is all about cash flow as a result the kind of information you need to calculate the quiddity. She owes is largely going to be found not from the income statement. Which is looking at the income and expenditure of the business over time or the cash flow statement. Which looks at the historical movements in cash.
The information you need for liquidity ratios is going to be drawn for what s known as the statement of financial position or mods. It s more commonly known the balance sheet the balance sheet. Is this snapshot of what the business owns or is owed. Which is the assets and what it owes to others.
Which are the liabilities. So the concept of liquidity essentially requires you to consider and compare two different types of information from the balance sheet. The current assets of the business and compare them with the current liabilities of the business. Let s just quickly look at what we mean by current assets and current liabilities.
Perhaps one of the most common current assets of a business is the cash. The cash in hand or the cash in at the bank that the business has most businesses operate with at least some cash in the bank. But of course there are two other main types of current asset. There is the stock or the inventories that are held by the business perhaps at the warehouse.
Perhaps as work in progress or raw materials that are flowing through the production process for a manufacturing business. So a lot of businesses. Particularly manufacturing businesses hold significant stocks as of course to retailers and wholesalers and thirdly and this happens in just about all businesses of any major size you ve got amounts that are owed to the business by customers known as trade debtors..
These are customers who ve been allowed to have sales allowed to have the product in return for agreeing to pay their invoices. A little bit later trade debtors. So those are the three main categories of current assets. And what we need is those current assets to be enough to be able to pay what the business.
Owes. Which are known as current liabilities. Two main ones to look out for firstly of course. And this again is its common in most businesses amounts that are owed to suppliers.
So in this case. We typically call these trade creditors where the supplier has provided us with some goods and services. We owe them the money and we should be paying that that invoice from the supplier at the right time at some stage in the future. The second current liability to look out for and this can happen at the same time as a business having cash in hand or at the bank is an overdraft facility or an overdraft amount owed to the bank which in theory is repayable on demand and therefore needs to be included in current liabilities.
So we can see we compare current assets with current liabilities. And the concept of liquidity is to see what the relationship is between the two of them let s look therefore at a really simple example just to show you how the main liquidity ratio. She s known as the current ratio how that is calculated so in this case with a very simple business and this is a snapshot of some of the information from the balance sheet the balance sheet data had cash in hand of. 10000.
Pounds it was holding stocks or inventories at a cost of 30000. Pounds that s tied up in in. Stocks and it was also. Owed.
60000. Pounds by its customers trade debtors of 60000. Pounds on the other side of the equation..
Amounts that the business needs to pay out at some stage in. Future it owned its creditors likely to be suppliers. 45000 pounds and it also had a 5 5000. Pound bank overdraft money it had effectively loaned from the bank that s our simple example let s now have a look at how we calculate the most popular the most common liquidity ratio.
It s known as the current ratio and it s really easy all you do is you divide current assets by current liabilities. So add them all up together to start with so our cash of 10. Our stocks of 30 are trade debtors of 60 gives us total current assets of 100000. Pounds.
We add together the current liabilities of the the trade creditors of 45. Plus the bank overdraft of 5 that gives us total current liabilities of 50000. Pounds and the way you calculate the current ratio is really easy you divide one by the other current assets over current liabilities. 100.
50. Should even with my maths give you the answer to so the current ratio is two in other words current assets are twice the level of current liabilities. Well that s your ratio calculator. But i guess the most important thing is what does it mean now the textbooks will all describe this in different ways.
But essentially most businesses would want to have a positive current ratio of more more than one in other words. They ve got current assets that are at least enough to be able to pay the amounts that it owes and typically a ratio of between one and a half two and a half maybe one and a half to three would suggest that actually the businesses is in decent position in terms of liquidity. It s got enough current assets to to pay the bills as they fold. You by contrast at a low current ratio of below one might suggest that the business is struggling to pay its pay its current liabilities of course.
It s possible to have a very high current ratio. And that also to be a problem so coat ratio. Say five six maybe..
Ten would suggest that there s far too much capital invested in the business. Perhaps tied up in in excess stocks or we ve allowed our trade debtors our customers to take too much credit. The key thing about top grade evaluation of using the current ratio is just think about what the number means in context. So for example it depending on which business or industry.
You re looking at the current ratio will vary take a look at major manufacturers or businesses. That are involved in long term contracts. They often have a substantial amount tied up in working progress and inventories in some industries. It s very common for customers to be given long periods to pay their debts and therefore trade debtors tend to be very high.
So. The key issue is what type of business are you looking at and what are the typical levels of the current ratio and also how does that ratio compare with competitors. Because that will give you an indication as to whether a business s is competitive in terms of its liquidity position. The other key thing to remember is to look out for the trend.
So don t just calculate the ratio. The current ratio at one point calculated over a series of periods and see whether it s going up or down. Because a sudden deterioration in the ratio could be a good indication that the business has got some cashflow problems that s the current ratio. And i think for most examples.
That is currently the the most certain the most popular and in some cases. The only liquidity ratio you require to know so check your exam board. But you may also come across this one which i ll just mention briefly for a minute or so. And it s known as the acid test ratio and don t worry about the name.
It s really a very simple ratio. It s the current ratio. But you make one small adjustment..
What is different about the acid test ratio compared to the current ratio is that you eliminate the current asset. That is typically hardest to turn into cash and that s inventories. So you imagine cash is easy. That s cash and trade s s you just get them to pay.
But with stocks and inventories. You actually have to turn them into a sale and then perhaps wait for that sale to be paid for you so inventories can be typically quite difficult to turn into cash in the short term. So the acid test is if you like a more stringent test of liquidity. But then you then compare it with exactly the same current liabilities that you that you have calculated with the current ratio.
So if we did that with our simple example remember we had a hundred thousand of current assets. But of that thirty thousand pounds was tied up in inventories or stocks if we take those out of current assets divided by fifty thousand. We see that the acid test ratio is less than two as you would expect it s one point four. How do you evaluate this well.
I guess the same comments as we made a few minutes ago are also true that you ve got to understand what type of business. You re looking at for some taking inventories out of current assets has a very significant impact on the ratio on the asset test ratio. But for service businesses. Almost no impact because very few services service businesses hold a little stock so you ve got to look out for what type of industry.
It is but also not be too concerned if it s if the ratio is poor. But the business has a high stock turnover so supermarkets typically operate on quite a low current ratio and acid test ratio. But it s not a problem for them because they re constantly turning that high level stock over through sales and in particular turning it into cash. So there we go that s a brief introduction to liquidity ratios.
The most important of which is the current ratio and in other topic videos we ll take a look at how we can use liquidity ratio information to help identify ways of improving the cash flow. ” ..
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