The importance of liquidity to a company

Why liquidity matters

• Suppliers, employees, lenders and the tax authority must be paid on time. Failure to pay can lead to legal action and insolvency, even for a profitable company.
• Poor liquidity means lost cash discounts, higher borrowing costs and damaged credit ratings.
• Good liquidity lets the company take opportunities (bulk buying, investment).
• Too much idle cash is also a weakness: it earns little and could be invested.

Profit and cash can diverge

• Large purchases of non-current assets (cash out, only depreciation in profit)
• Rapid growth, or overtrading: inventory and receivables grow faster than cash comes in
• Repaying loans or paying dividends (not expenses)
• Credit given to customers longer than credit received from suppliers

Reading liquidity

• Statement of cash flows: is operating cash flow positive and covering interest, tax and dividends? Is investment funded by long-term finance or by an overdraft?
• Ratios: current ratio (often around 1.5 to 2 : 1), liquid ratio (about 1 : 1), receivables and payables days, working capital.
• Ways to improve: chase receivables, offer cash discounts, reduce inventory, negotiate longer supplier credit, sell and lease back assets, raise long-term finance, delay capital spending.

Examiners rewarded extra calculations (current ratio, liquid ratio, working capital) in liquidity evaluations, and expected the answer to be applied to the company.

Worked example

A company made a profit for the year of £600,000 but its cash fell by £250,000. Suggest three possible reasons.

1. It bought non-current assets: the full cost is a cash outflow, but only depreciation reduces profit
2. Inventories and trade receivables increased, tying up cash
3. It repaid a loan or paid dividends, which reduce cash but are not expenses

Answer: Profit includes non-cash items and excludes capital and financing flows, so cash can fall while profit is earned

Check yourself

1. What is liquidity?
   • The level of profit for the year
   • The market value of the shares
   • The total of non-current assets
   • The ability to pay debts as they fall due
   Show answer

   The ability to pay debts as they fall due. Liquidity is about having cash (or near-cash) to meet obligations.

2. A company grows sales by 80% in a year, but runs out of cash. What is this called?
   • Gearing
   • Overtrading
   • Capitalisation
   • Realisation
   Show answer

   Overtrading. Growth ties up cash in inventory and receivables faster than it comes in.

3. Which action would improve a company's liquidity?
   • Paying suppliers earlier
   • Buying extra inventory for cash
   • Paying a larger dividend
   • Reducing the credit period given to customers
   Show answer

   Reducing the credit period given to customers. Collecting from customers sooner brings cash in faster.

4. Current assets are £540,000 and current liabilities £600,000. Calculate working capital. Give a negative number if it is negative.
   Show answer

   £-60000. 540,000 - 600,000 = -£60,000: net current liabilities.

5. Current assets £780,000; current liabilities £520,000. Calculate the current ratio to 2 decimal places.
   Show answer

   1.50 : 1. 780,000 / 520,000 = 1.50 : 1.

6. Explain why a profitable company could still become insolvent.
   Show answer

   Profit is not the same as cash: if cash is tied up in inventory, receivables or new non-current assets, the company may not have enough cash to pay its suppliers, lenders and other debts when they fall due.. Insolvency is about being unable to pay debts on time, which depends on cash, not profit.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Accounting specification (XAC11/YAC11), Issue 2
• Pearson Edexcel IAL Accounting WAC12 examiners' report, October 2022

Last updated 8 November 2026. Spotted a mistake? Tell us.