Page 290 - Cambridge IGCSE Business Studies

Cambridge IGCSE Business Studies Section 5 Financial information and decisions

Liquidity
KEY TERM
If a business does not have enough cash to pay for its immediate expenses or short-term
Liquidity: the ability of a liabilities (business debts), and has no access to cash from internal or external sources, it
business to pay its short-term
will not be able to continue trading. A business’s liquidity is its access to cash.
debts.
Current assets are important to a business because they indicate how much cash
a business has access to in order to meet its short-term liabilities.
Liquidity is so important to a business’s survival that it must be carefully
managed at all times. One way of monitoring a business’s liquidity is through the
Assets and liabilities: see use of the following liquidity ratios:
Chapter 22, page 277.
■ current ratio
■ acid test ratio.

To help with our calculation and understanding of these ratios we are going to use a
further extract from the accounting statements of Tang Toys Ltd.

2012 2013

$000 $000
Current assets 60 50

Current assets – inventories 20 30
Table 23.4 Extract from the
Current liabilities 40 30
balance sheets of TT

288 Current ratio
KEY TERM Th e current ratio shows the ratio between current assets and current liabilities.

Current ratio: ratio between Current ratio = current assets
current assets and current current liabilities
liabilities.
Current assets represent things owned by the business which are already in the
form of cash, or are easy to convert into cash. Current liabilities are the short-term
debts of a business, which are expected to be paid in the near future. Th erefore,
it is important that the level of current assets is greater than the level of current
liabilities. If this is not the case, then the business risks liquidity problems. Th ere is
not enough cash coming into the business to pay its short-term liabilities and have
spare cash for unexpected expenses.

EXAMPLE

Using the data from Table 23.4, the 2012 current ratio for TT is:

60
Current ratio (2012) =
40
= 1.5 : 1

(Note that the result is always shown as a ratio.)
For every $1 of current liabilities TT has $1.5 of current assets: that is it has access to more cash than it needs to meet its
short-term liabilities and has spare cash to pay for any unexpected expenses.