This further example will help you to understand how the timing of payments is critical to an assessment of short-term liquidity, as covered on pages 373-375 (Current liabilities: the timing of payments) of Chapter 9.

Example

Charlie has taken out a mortgage with which to buy a house on 31 December 2021. His monthly repayments on this mortgage are £1,000 per month payable at the end of each month, the first instalment being due on 28 January 2022. He also owes council tax for the coming year of £1,500 (= £125 a month, £1,500 ÷ 12) as well as £300 a month for a loan he took out two years ago to buy a car. Charlie’s monthly salary paid into his bank account after tax and national insurance is £2,500 and at the end of December 2021 he has £500 in the bank. How liquid is Charlie?

If Charlie were a company, we would say that at 31 December 2021 he owed £1,000 x 12 months = £12,000 on his mortgage along with the £1,500 owed for council tax and £300 x 12 = £3,600 on his car loan, all liabilities due within the next 12 months. At 31 December 2021, Charlie thus has £17,100 of liabilities due within 12 months and £500 in the bank at that date. Charlie’s current ratio at 31 December 2021 is 0.03:1 (£500/£17,100), 3 pence of cash for every £1 of liabilities due within the next year. However, no one would suggest that Charlie is bankrupt or facing cash flow difficulties as he has a net salary each month from which to pay his debts and to live on of £2,500. After deducting his mortgage, car loan and monthly instalment on the council tax, he is left with £1,075 (£2,500 – £1,000 – £300 – £125 (£1,500/12)) to pay his utility bills, run his car, feed and clothe himself.

Charlie thus has a steady inflow of cash from which to meet his liabilities as they fall due. Timing of the payment of the liabilities is thus everything. If Charlie had to meet all these liabilities on 1 January 2022, he would be insolvent as he would not be able to meet all these payments from the £500 in the bank. In the same way, companies do not have to meet all their year-end liabilities all at once but will spread these over the next year and meet them from the steady cash inflows arising from daily sales and cash inflows from those sales.

Companies are in exactly the same position as Charlie and directors know that cash will be generated on a daily, weekly and monthly basis to meet liabilities as they fall due. Even though the statement of financial position shows liabilities due within the next twelve months and insufficient current assets to meet all these liabilities immediately, cash will become available to meet these liabilities as they come up for payment. It is when the cash that will be available is insufficient to pay liabilities that are due that companies become insolvent, but careful forward planning and cash budgeting (see Chapter 14 on cash budgeting)should enable companies (and individuals) to make sure that they have sufficient cash with which to meet their commitments as they become payable.