Liquid assets are assets that can be easily converted into cash with minimal loss of value. Illiquid assets are assets that are difficult to convert into cash quickly without a significant loss in value.

Examples of liquid assets:

• Cash and bank balances: These are readily available for immediate use.
• Short-term deposits: These can be withdrawn quickly, usually within a short notice period.

Examples of illiquid assets:

• Property, plant, and equipment (PP&E): Selling these can take time and may require price reductions.
• Long-term investments: These are often difficult to sell quickly and may not yield immediate returns.

Effective liquidity management is crucial for a business for several reasons:

• Meeting short-term obligations: Ensures the business can pay its bills, such as suppliers, salaries, and loan repayments.
• Avoiding financial distress: Sufficient liquidity reduces the risk of insolvency and potential business failure.
• Taking advantage of opportunities: Having readily available cash allows the business to seize unexpected opportunities, such as discounted purchases or new investment possibilities.
• Maintaining stakeholder confidence: Demonstrates financial stability to lenders, investors, and customers.

Current Ratio Calculation:

Current Assets = Inventory + Receivables + Cash = £15,000 + £22,000 + £3,000 = £40,000

Current Ratio = Current Assets / Current Liabilities = £40,000 / £8,000 = 5

Interpretation: A current ratio of 5 indicates that the company has £5 of current assets for every £1 of current liabilities. This is a very strong liquidity position. It suggests the company is highly liquid and can easily cover its short-term debts.

Acid Test Ratio Calculation:

Acid Test Assets = Receivables + Cash = £22,000 + £3,000 = £25,000

Acid Test Ratio = Acid Test Assets / Current Liabilities = £25,000 / £8,000 = 3.125

Interpretation: The acid test ratio of 3.125 shows that the company has £3.125 of acid test assets for every £1 of current liabilities. This is also a very strong liquidity position, confirming the company's ability to meet its immediate obligations even without relying on inventory.

Strengths and Weaknesses of Using Liquidity Ratios:

• Strengths:

  • Provide a quick assessment of a company's ability to meet its short-term liabilities.
  • Easy to calculate and readily available from financial statements.
  • Allow for comparison with industry averages and competitors.
  • Help identify potential liquidity problems early on.

• Weaknesses:

  • Do not consider the quality of current assets. For example, high receivables may not be easily converted to cash.
  • Can be misleading if the company has unusual or non-standard accounting practices.
  • Do not provide information about long-term solvency.
  • Industry averages can be misleading if the company operates in a sector with different working capital requirements.

Therefore, while liquidity ratios are valuable tools, they should be used in conjunction with other financial analysis techniques to get a comprehensive understanding of a company's financial health.

Current Ratio Calculation:

Current Assets = Stock + Debtors + Cash = £12,000 + £20,000 + £5,000 = £37,000

Current Ratio = Current Assets / Current Liabilities = £37,000 / £10,000 = 3.7

Interpretation: A current ratio of 3.7 indicates that XYZ Company has £3.70 of current assets for every £1 of current liabilities. This is a very strong liquidity position. It suggests the company has ample resources to cover its short-term debts. A ratio this high might indicate that the company is not effectively utilizing its current assets, such as holding too much cash or inventory.

Acid Test Ratio Calculation:

Acid Test Assets = Debtors + Cash = £20,000 + £5,000 = £25,000

Acid Test Ratio = Acid Test Assets / Current Liabilities = £25,000 / £10,000 = 2.5

Interpretation: The acid test ratio of 2.5 shows that XYZ Company has £2.50 of acid test assets for every £1 of current liabilities. This is also a very healthy liquidity position. It indicates that even without relying on inventory, the company has sufficient liquid assets to meet its immediate obligations. This is a positive sign for the company's ability to pay its debts.

What the Ratios Reveal:

• The high current ratio and acid test ratio for XYZ Company demonstrate a strong ability to meet its short-term liabilities.
• The company has a significant buffer of liquid assets, which reduces the risk of financial distress.
• The ratios suggest that the company is well-managed and has effective working capital management.
• However, it's important to consider the industry context. While these ratios are strong, they should be compared to industry averages to determine if they are truly optimal.