In the latter part of the VCE Accounting course, students focus extensively on evaluating the financial performance of businesses. An integral part of such evaluation is analysing liquidity. If businesses fail to maintain adequate liquidity, then they will struggle to meet their debt obligations. In the first part of this two-part blog on liquidity analysis, we define liquidity and outline the key measures of short-term liquidity that are covered in the VCE Accounting curriculum.
Defining Liquidity
Liquidity is defined as the ability of a business to meet short-term debts when they fall due. The importance of recalling and understanding definitions cannot be overstated. Be sure to invoke the definition of liquidity when conducting a financial performance analysis that addresses it!
Three Measures of Liquidity
In the VCE Accounting course, we study three primary measures of liquidity. These measures are commonly analysed in the real world, so we see a rewarding connection between the classroom and real-life business scenarios in this topic.
The three key measures of liquidity are set out below.
1. Working Capital Ratio (WCR)
The working capital ratio determines the ratio of current assets to current liabilities for a business. Think of it as the number of dollars in current assets the business has, for every dollar in current liabilities.
The formula for the working capital ratio is:
It is desirable to have a working capital ratio in excess of 1:1 - this indicates that the business is able to service its current liability obligations with its current assets. However, a working capital ratio that is too high is undesirable as well. It is difficult to quantify what it means for the working capital ratio to be too high - it really depends on other aspects of the business as well as the industry in which it operates.
Nonetheless, at high levels, the business is likely misallocating its resources, under-investing its current assets, such as cash or inventory, in more profitable non-current assets.
2. Quick Asset Ratio (QAR)
The formula for the quick asset ratio is:
At face value, the Quick Asset Ratio seems very similar to the working capital ratio. However, the key distinction between these two measures of liquidity is that the quick asset ratio captures the liquidity of the business over a much shorter period. It determines the ability of the business to meet its immediate short-term debts when they fall due using its liquid assets.
What we mean by liquid assets is those that are cash, or can be quickly converted to cash, to then be used to settle debt obligations. Some current assets, like inventory, take time to convert to cash - they must be sold first. Therefore, such assets are excluded from the quick asset ratio formula.
Like the working capital ratio, businesses aim for a quick asset ratio above 1:1, indicating a strong capacity to meet immediate short-term debts when they fall due using liquid assets. Notice that the denominator in the working capital ratio and quick asset ratio formulas is identical. The only difference between the formulas is that the quick asset ratio formula calculation subtracts inventory and prepayments. Therefore, a large gap between the working capital ratio and the quick asset ratio indicates that the business has a relatively large stockpile of inventory and/or prepaid expenses, suggesting a potential misallocation of resources.
3. Cash Flow Cover (CFC)
A financially sound business is able to settle its short-term debt obligations using cash it generates from its primary revenue-earning activities. The cash flow cover ratio determines whether a business is able to service its current liabilities using its net cash flows from operating activities.
The formula for the cash flow cover ratio is:
The optimal value for this ratio is anything greater than 1:1. This indicates that the business generates sufficient net cash flows from its day-to-day trading activities to meet its current liabilities when they fall due.
Conclusion
In this first part of our exploration into liquidity analysis for VCE Accounting, we've delved into the foundational concepts and key measures essential for evaluating the financial health of businesses. Understanding liquidity is crucial for assessing a company's ability to meet short-term obligations, a skill that's invaluable both in exams and real-world scenarios.
Stay tuned for part two, where we'll put these concepts into action with a practical application to a fictional business scenario. Just as we've seen the importance of mastering the double-entry accounting system as a fundamental skill, grasping liquidity analysis will serve as a cornerstone throughout your VCE Accounting journey. Keep honing your understanding and application of these concepts – they're indispensable tools for success in both your studies and future endeavours.
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