Calculating Liquidity
What is liquidity?
• liquidity means how much money the firm has
to spend and invest.
• The higher the liquidity, the more cash or
‘near cash’ available in the firm in comparison
to the demands that there are on this cash.
• ‘near cash’ are assets of the firm that are
nearly as good as cash – debtors who are likely
to pay debts soon, or stock that is likely to be
sold.
So liquidity is a measure of the money available to a firm for
spending, in comparison to the money that has to be spent.
From your point of view, if you have £80 in cash and in the bank to last the month,
and during the month you have to pay £20 for travel and repay a loan from
a friend of £10 your liquidity is good £80 v £30, giving £50 spare.
But if you had to pay for your lunches costing £60 over the month,
we now have £80 v £90, liquidity is poor.
You might resolve this problem by walking
instead of catching a bus, buying cheaper lunches,
or delaying repaying your loan.
Working Capital
Working Capital is a measure of liquidity.
If working capital is high, then liquidity is good.
If working capital is low or even negative, then liquidity is poor.
Using the examples of money v spending on the last slide.
£80 in cash and in the bank to last the month,
during the month £20 for travel and repay a loan from
a friend of £10 your liquidity is good £80 v £30, giving £50 spare
= £50 of working capital
£80 in cash and in the bank to last the month,
during the month £20 for travel and repay a loan from
a friend of £10 plus your lunches costing £60 over the month,
we now have £80 v £90, £10 short of what is needed
= -£10 of working capital
Calculating Working Capital
2012
(m)
2011
(M)
247
231
Stock
147
141
Debtors
70
59
Cash and Bank
24
86
Total Current Assets
241
286
Current Liabilities
303
261
Net Current
Liabilities/Assets
(62)
25
Total Assets less Current
Liabilities
185
256
Long-term Liabilities
24
29
Shareholders’ Funds
161
227
Capital Employed
185
256
Fixed Assets
Current Assets
The figures we need are from the firm’s
Balance Sheet.
We need the total value of Current Assets,
and the total value of Current Liabilities.
We then simply take Current Liabilities
from Current Assets
CA – CL = Working Capital
Working Capital for 2011 is
–
= £25M
Working Capital for 2012 is
–
= -£62M
Working Capital is the same figure
as Net Current Assets
Calculating Liquidity
We can use two ratios to calculate liquidity, these are
•The Current Ratio
•The Acid Test Ratio
For both ratios we need to look at current assets and current liabilities
from the firms Balance Sheet– but for the Acid Test Ratio we do not use
‘stock’ in our calculations.
For the Current Ratio the formula is Current Assets : Current Liabilities
For the Acid Test Ratio the formula is Debtors + Cash : Current Liabilities
Calculating the Current Ratio
2012
(m)
2011
(M)
247
231
Stock
147
141
Debtors
70
59
Cash and Bank
24
86
Total Current Assets
241
286
Current Liabilities
303
261
Net Current
Liabilities/Assets
(62)
25
Total Assets less Current
Liabilities
185
256
Long-term Liabilities
24
29
Shareholders’ Funds
161
227
Capital Employed
185
256
Fixed Assets
Current Assets
For the Current Ratio the formula is Current Assets : Current Liabilities
To complete the calculation we take the
figure for CA, and divide by the figure for CL.
We show the answer as XX:1
So for 2011, we have
CA of £286M and CL of £261M
So divide 286 by 261, and we have
1.09 (2 decimal places is plenty).
So our figure for the Current Ratio is
1.09 :1
For 2012, we have
CA of £241M and CL of £303M
(in this case current assets are less than
current liabilities).
Again divide CA by CL, 241 by 303, and
we have 0.79 (2 decimal places).
So our figure for the Current Ratio is
0.79 :1
Commenting on the Current Ratiowhat do the figures we have calculated tell us?
For 2011, we have a Current Ratio of 1.09 :1
For 2012, we have a Current Ratio of 0.79 :1
First of all remember we are measuring ‘liquidity’ - how much money the firm
has to spend and invest.
To have a good level of liquidity the firm should have more Current Assets than
Current Liabilities. This would be shown by the ratio being more than 1:1.
So the Current Ratio could be 1.2:1, 1.5:1, or as much as 4:1.
The figures for the Current Ratio are 1.09:1, and 0.79:1. These indicate, a low and
worsening level of liquidity. The firm may have problems meeting demands for
payments from creditors and others (the bank if they have an overdraft). They are short
of Working Capital.
But what is an acceptable Current Ratio? What should a firm be aiming for?
An acceptable Current Ratio - a good level of liquidity,
or working capital
As a guide to liquidity, if the Current Ratio figure is:
• above 1.5:1, we can say that liquidity is good
• between 1.5:1 and 1: 1, we can say it is reasonable
• below 1:1, we can say it is poor
But do not treat the above figures as a fixed rule. Some firms happily survive on low
current ratios. These typically are businesses with a high level of stock turnover,
who deal in cash.
Good examples of this type of firm are supermarkets.
Tesco quite happily survives on a current ratio of about 0.4:1
Calculating the Acid Test Ratio
Fixed Assets
2012
(m)
2011
(M)
247
231
Current Assets
Stock
147
141
Debtors
70
59
Cash and Bank
24
86
Total Current Assets
241
286
Current Liabilities
303
261
Net Current
Liabilities/Assets
(62)
25
Total Assets less Current
Liabilities
185
256
Long-term Liabilities
24
29
Shareholders’ Funds
161
227
Capital Employed
185
256
For the Acid Test Ratio the formula is Debtors + Cash : Current Liabilities
So we add together the figures for
Debtors and Cash (at bank),
and divide by the figure for CL.
We show the answer as XX:1
So for 2011 the figures are;
£59m + £86m : £261m
= Acid Test Ratio of 0.55 : 1
And for 2012 the figures are;
£70m + £24m : £303m
= Acid Test Ratio of 0.31 : 1
Commenting on the Acid Test Ratio
For 2011, we have an Acid Test Ratio of 0.55 :1
For 2012, we have an Acid Test Ratio of 0.31 :1
As a guide to liquidity, if the Acid Test Ratio figure is:
• above 1:1, we can say that liquidity is good
• between 0.8:1 and 1:1, we can say it is reasonable
• below 0.8:1, we can say it is poor
But as with the Current Ratio do not treat these figures as a fixed rule. Some
firms happily survive on low Acid Test ratios. Again these are businesses with a
high level of stock turnover, who deal in cash and those with good financial
management of the other current assets and current liabilities.
Commenting on the Acid Test Ratio
If we look at the Acid Test Ratio, we see a figure of 0.55:1 for 2011, this tells us that
liquidity is poor, and the business may have problems if creditors demanded the money
they are owed.
The working capital situation gets worse over the year, with the ratio falling to 0.31:1,
the firm has nowhere near enough current assets to meet potential demands from
creditors.
Calculate the firms Current Ratios and
Acid Test Ratios for both years.
Comment on your findings.
So for 2009 the figures are;
Current Ratio
2543 : 1379 = 1.84 : 1
Acid Test Ratio
2450 : 1379 = 1.77 : 1
Was it worth calculating the ATR?
So for 2010 the figures are;
Current Ratio
3063 : 1549 = 1.97 : 1
Acid Test Ratio
2980 : 1549 = 1.92 :1
Was it worth calculating the ATR?