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Liquidity
UNIT 4 CH 19
| Question | Answer |
|---|---|
| Liquidity: | ability of a business to meet its short-term debts as they fall due. |
| Role of the budgeted CFS in evaluating liquidity. | details all expected cash inflows + cash outflows, + states categorically whether the business will be able to meet its cash obligations for the coming RP. |
| 3 indicators that are used to assess the level of liquidity. | WCR, QAR + CFC |
| 3 indicators that are used to assess the speed of liquidity. | STO, DTO, CTO |
| What is measured by the Working Capital Ratio (WCR). | Liquidity indicator that measures the ratio of CA to CL, to assess the firm’s ability to meet its short-term debts. |
| WCR formula: | WCR = CA/CL |
| Why should the WCR should be at least 1:1. | this indicates that there is at least $1 of CA available to meet every $1 of CL. Signifying firm is able to meet all its short-term debts as they fall due. |
| 1 problem associated with an excessive WCR: | Excess CA = idle + not being employed effectively eg bank: excess $ could be invested; e.g.SC large amounts incur storage costs/stock loss/damage, e.g. DC: indicate poor collection procedures, increasing the chance of bad debts. |
| 2 actions the owner may be required to take if WCR too low: | –Make a (cash) capital contribution. __ Seek additional finance by entering into, or extending, an overdraft facility. __ Take out a loan to purchase non-current assets. |
| 2 actions the owner may be required to take if WCR too low: | – Use excess cash by repaying debts, purchasing NCA or taking extra drawings. __ Allow stock levels to run down before reordering. __ Contact debtors to collect amounts outstanding. |
| What is measured by the Quick Asset Ratio (QAR). | liquidity indicator that measures the ratio of quick A to quick L, to assess the firm’s ability to meet its immediate debts. |
| WAR formula: | QAR) = CA (excluding Stock and Prepaid E/ CL(excluding BO) |
| Why SC excluded from calculation of QAR: | there is no guarantee that all of a firm’s stock can be suddenly sold |
| Why prepaid E excluded from calculation of QAR: | – these cannot normally be converted back into cash because a business has entered into a contract and is unlikely to be able to get a refund |
| Why OE excluded from cal of QAR: | unlikely that a BO will be called in for repayment as long as it remains under the limit. |
| What is indicated if the WCR is satisfactory, but the QAR is unsatisfactory. | firm has large investment in stock + prepaid E. Given the difficulties in liquidating prepaid E, firm’s ability to meet its debts will depend heavily on its ability to sell its stock on time. If this does not happen, it will face liquidity problems. |
| What is measured by the Cash Flow Cover (CFC). | liquidity indicator that measures the number of times net cash flows from operations is able to cover average CL. |
| CFC formula: | CFC = Net Cash Flows from Operations/Av CL |
| 3 benchmarks that could be used to assess the adequacy of the Cash Flow Cover. | CFC from previous periods __ Budgeted CFC __ CFC of similar businesses |
| Explain how a firm with a high turnover can remain solvent despite an unsatisfactory level of liquidity. | Can remain solvent if speed of trading is fast enough. = if a business can sell its stock (+ collect the $ from its customers) before that cash is needed, it will be able to survive even with an unsatisfactory WCR |
| Define the term ‘efficiency’ as it relates to the assessment of business performance. | Efficiency is the firm’s ability to manage its stock, debtors and creditors. |
| State what is measured by Stock Turnover (STO). | STO measures the average number of days it takes for a business to convert its stock into sales. |
| Show the formula to calculate STO | STO = Average Stock x 365/Cost of Goods Sold |
| Explain why fast Stock Turnover is beneficial for liquidity. | Fast STO (measured by low days) means that, on average, stock is sold quickly. This will enhance the firm’s ability to generate cash from the sale of stock, and improve its ability to pay its short-term debts. |
| State two actions that an owner could take to improve Stock Turnover. | Employ strategies to increase sales = advertising, changing SP or changing the stock mix.___Decrease lvl of stock on hand by ordering less, ordering smaller amounts more frequently (just-in-time ordering) or replacing slow-moving stock lines. |
| Explain one advantage of fast Stock Turnover. | improves liquidity by generating cash faster, or improves profitability by generating more sales, or less chance of stock loss/damage or lower storage costs due to lower levels of stock on hand |
| one disadvantage of fast Stock Turnover. | disadvantage – loss of potential R if SP are set too low, delivery costs may be higher due to more frequent deliveries, loss of possible discounts for bulk-buying |
| Explain the role of stock cards in an analysis of Stock Turnover. | provide more detailed info about speed at which specific lines of stock are selling, so appropriate decisions can be made e.g. discounting or discontinuing a slow-moving line of stock, or ordering more of the fast-moving lines. |
| Explain 4 strategies that businesses should use to manage their stock. | review sales to maintain appropriate stock mix, promote sale of complimentary goods, ensure stock is up to date, rotate stock, maintain appropriate lvls of stock on hand, employ strong marketing |
| Review sales to maintain an appropriate stock mix | stock lines that are selling well should be expanded, while those that are not should be reduced or even discontinued |
| Promote the sale of complementary goods | those ‘add-ons’ should be carefully considered so that they can generate additional sales |
| Ensure stock is up-to-date | sales of some stock lines are affected by changes in fashion or technology and thus should be discounted for quick sale |
| Rotate stock | ensure the older products (particularly if perishable) are positioned at the front of the shelf to encourage sales; this will minimise stock loss/write-down issues |
| Determine an appropriate level of stock on hand | levels should be sufficient to meet demand, but not so high that additional storage costs or stock write-down issues ensue |
| Employ strong marketing | strategies such as advertising will hopefully lead to increased sales and faster Stock Turnover. |
| State what is measured by Debtors Turnover (DTO). | DTO measures the av no. of days it takes for a business to collect cash from its debtors. |
| Show the formula to calculate Debtors Turnover. | DTO = Average Debtors x 365/Credit Sales |
| Explain why Debtors Turnover is crucial to an assessment of liquidity. | crucial in assessing how quickly it takes a business to collect $ from D. If $ is collected quickly, it can be used to meet short-term debts. IF $ not collected quickly, a firm may not be able to meet short-term debts + may face liquidity problems. |
| Explain the importance of credit terms offered to customers in assessing Debtors Turnover. | most ideal benchmark to use in assessing DTO. This is BCUZ it can be compared against the DTO calculated for the RP - owner can note whether debt collection procedures have been enforced, then act to improve any shortcomings. |
| strategies a business could use to improve its DTO in the order in which they should be implemented. | 1 extensive credit checks ___ 2 prompt invoicing ___ 3.discounts for quick settlement ___ 4 reminder notices ___ 5 threats of legal action ___ 6 debt collection agency ___ 7 threats of not providing credit in the future |
| State what is measured by Creditors Turnover (CTO). | measures the average number of days it takes for a business to pay its creditors. |
| Show the formula to calculate Creditors Turnover. | CTO = Averages Creditors x 365/Credit Purchases |
| Explain the relationship between Stock and Debtors Turnovers, and Creditors Turnover. | Firm’s ability to pay C - CTO relies heavily on ability to generate $ from stock = reliant on selling stock AQAP (STO), if firm deals mainly on credit, collecting $ from D AQAP - DTO. |
| Explain the relationship between Stock and Debtors Turnovers, and Creditors Turnover if STO improves | If no of days it takes to convert stock into $ improves, then $ is available more quickly, so firm is able to pay C faster. |
| State three negative consequences of exceeding the credit terms offered by suppliers. | interest charges on late accounts ___removal of credit facilities ____reduction in credit rating |
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