Analysis Of Accounts: Liquidity (Copy)
Cheat Sheet: 5.5.2 Liquidity
Concept of Liquidity
| Term | Definition | Example |
|---|---|---|
| Liquidity | Ability of a business to pay its short-term debts using current assets | Firm has $50,000 current assets and $30,000 current liabilities → liquid position |
| Illiquidity | When a business cannot meet short-term obligations, even if profitable | Profitable company but no cash to pay rent |
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Business Studies Full Scale Course
Importance of Liquidity
| Importance | Explanation | Example |
|---|---|---|
| Survival | Prevents insolvency and closure | Firm pays wages and suppliers on time |
| Smooth Operations | Ensures continuity of production & sales | Manufacturer buys raw materials regularly |
| Confidence | Builds trust with creditors and banks | Bank approves overdraft due to strong liquidity |
| Flexibility | Allows seizing new opportunities quickly | Business buys discounted bulk stock |
Liquidity Ratios (Preview)
| Ratio | Formula | What It Shows |
|---|---|---|
| Current Ratio | Current Assets ÷ Current Liabilities | Should ideally be around 1.5–2:1 |
| Acid Test Ratio | (Current Assets – Inventories) ÷ Current Liabilities | More strict test of liquidity |
(Full ratio calculations covered in 5.5.3.)
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Business Studies Full Scale Course
Quick Revision Bullets
- Liquidity = ability to pay short-term debts
- High liquidity = stability; Low liquidity = risk of failure
- Profit ≠liquidity → firm may have profit but no cash
- Ratios used: Current Ratio, Acid Test Ratio
- Liquidity ensures survival, smooth operations, and creditor confidence
Written and Compiled By Sir Hunain Zia, World Record Holder With 154 Total A Grades, 7 Distinctions and 11 World Records For Educate A Change O Level And IGCSE Business Studies Full Scale Course