Liquidity — Edexcel A-Level Business
Test yourself on Liquidity with PEARSON EDEXCEL A-Level practice questions.
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Liquidity explained
Liquidity asks a narrower question than profitability: can this business pay what falls due within the next twelve months?
Read the full explanation
Divide current assets by current liabilities and quote the answer as so many to one; then repeat with inventory stripped out, because unsold stock is the slowest item on the list to turn into money. A manufacturer holding raw materials can look comfortable on the first measure and alarming on the second. Textbooks suggest around one and a half to one for the first and about one to one for the second, yet Tesco trades safely below both because shoppers pay at the till while suppliers wait. Improvement comes from collecting from customers faster, factoring invoices, cutting stock, negotiating longer supplier credit, or converting short term debt into long term finance, and each has a price.
b) Working capital and its management: the importance of cash
This is the money circulating through the daily running of the business, found by taking current liabilities away from current assets, and managing it means controlling three things: how much stock sits in the warehouse, how quickly customers pay, and how long suppliers can be kept waiting. The cycle matters more than the snapshot. A firm that settles supplier invoices in thirty days but collects from its own customers in ninety has to fund that gap, usually through an overdraft that charges interest. Hold too little and the wage run fails; hold too much and money is trapped in stock and unpaid invoices that earn nothing. Just in time delivery shortens the cycle sharply but removes the buffer when a supplier lets you down, which is the trade-off the judgement turns on.
Your focus
- a) Statement of financial position (balance sheet): measuring liquidity: calculating current ratio and acid test ratio; ways to improve liquidity
- b) Working capital and its management: the importance of cash
Liquidity exam tips
Marking Points
- Correct method: current assets divided by current liabilities, and the second ratio with inventory removed from current assets, both expressed as a figure to one.
- Judgement against a benchmark and against last year, with the point that the ideal level depends on the industry and the business model.
- An improvement method matched to the firm's actual problem, such as debt factoring where receivables are large and slow to arrive.
- Recognition that a figure which is too high is also a fault, since idle money and excess stock earn nothing for the owners.
- Definition through the calculation, current assets minus current liabilities, with the point that it funds daily trading rather than long term assets.
- The cycle explained in order: money into stock, stock into sales, sales into amounts owed by customers, and those amounts back into the bank.
- A named technique with its effect, such as tightening credit terms speeding collection while risking the loss of customers to a rival.
- Application to the named business, for example a seasonal firm whose requirement peaks in the months before its selling season.
Examiner Tips
- 💡Quote the answer as a ratio to one rather than as a percentage, and carry two decimal places when the figures are awkward.
- 💡A twelve mark question typically asks you to assess liquidity from a balance sheet extract, so calculate both measures, compare with the previous year, then judge.
- 💡Connect this to working capital and to business failure, since answers that link the three score higher than answers that treat the arithmetic as the whole task.
- 💡This pairs naturally with the liquidity ratios, so if you have already calculated the current ratio use it as evidence instead of repeating the working.
- 💡Higher mark questions ask whether a business should tighten credit control, so structure the answer as benefit, drawback and a judgement that depends on context.
- 💡Anchor the answer in a real pressure from the extract, such as one dominant customer paying late, because unapplied theory caps the mark.
Common Mistakes
- Leaving inventory inside the acid test, which makes the two results identical and wastes the second calculation entirely.
- Using total assets or non current assets in place of current assets, so the answer measures something else altogether.
- Recommending the sale of non current assets to raise money without noticing that the firm needs those assets in order to trade.
- Confusing this with capital employed or with the bank balance, when it is a net figure that includes stock and money owed by customers.
- Assuming more is always better, and missing that slow moving stock and overdue invoices are a cost rather than a comfort.
- Offering just in time as a cure with no mention of supply chain risk or of the supplier relationships it depends on.