Liquidity Meaning Ratios Examples Management Importance

Liquidity Meaning

When converting assets into cash or cash equivalents, firms should do so at a fair market price. Before investing a huge sum in any investment, companies need to ensure adequate liquid assets to meet operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more.

Key Takeaways

Liquidity is a method of interpreting a firm’s proficiency in fulfilling its short-term obligations using cash—acquired from the sale of its current assets at a fair market price.Cash ratio, quick ratio, current ratio, and defensive interval ratios measure a company’s financial health.Firms possessing more liquid assets have better credibility. They have sufficient working capital and cash reserves—better placed for business growth or expansion.

Liquidity Explained

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The meaning of the term liquidity varies depending on the context. Liquidity in financial markets refers to the convertibility of securities and assets into quick cash—without bargaining over market price. These short investments include cash, foreign currency, stocks, commoditiesCommoditiesA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units.read more, and government investment certificates. In accountingAccountingAccounting is the process of processing and recording financial information on behalf of a business, and it serves as the foundation for all subsequent financial statements.read more though liquidity refers to a firm’s competence in fulfilling short-term financial obligations.

Investors, shareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company’s total shares.read more, and credit providers judge a firm based on its liquidity before investing. Liquid assets are readily available in cash—cash equivalents, inventory, and receivables. Fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more, goodwillGoodwillIn accounting, goodwill is an intangible asset that is generated when one company purchases another company for a price that is greater than the sum of the company’s net identifiable assets at the time of acquisition. It is determined by subtracting the fair value of the company’s net identifiable assets from the total purchase price.read more, and trademark are not considered very liquid. Liquid assets should be balanced. Excessive cash or current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more may lead to a liquidity glut with more than the required free capital floating in the business. Such money remains uninvested and doesn’t generate any additional income or benefits.

Liquidity Ratios

Following are the different types of financial ratiosTypes Of Financial RatiosFinancial ratios are of five types which are liquidity ratios, leverage financial ratios, efficiency ratio, profitability ratios, and market value ratios. These ratios analyze the financial performance of a company for an accounting period.read more calculated by organizations to identify their financial well-being:

#1 – Current Ratio

The current ratioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it’ short-term loans within a year. Current ratio = current assets/current liabilities read more is a financial measure of an organization’s potential for meeting its current liabilities Current Liabilities Current Liabilities are the payables which are likely to settled within twelve months of reporting. They’re usually salaries payable, expense payable, short term loans etc.read morewithin a year from its existing assets. The formula is as follows:

Current assets comprise cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more, inventory, accounts receivablesAccounts ReceivablesAccounts receivables is the money owed to a business by clients for which the business has given services or delivered a product but has not yet collected payment. They are categorized as current assets on the balance sheet as the payments expected within a year. read more, marketable securitiesMarketable SecuritiesMarketable securities are liquid assets that can be converted into cash quickly and are classified as current assets on a company’s balance sheet. Commercial Paper, Treasury notes, and other money market instruments are included in it.read more, money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more instruments, and other assets that can be readily converted into cash. In comparison, current liabilities include short-term debtsDebtsDebt is the practice of borrowing a tangible item, primarily money by an individual, business, or government, from another person, financial institution, or state.read more, outstanding salaries, wages, electricity expenses, rent, taxes, and long-term debt installments.

A proportion of 2:1 defines sound working capitalWorking CapitalWorking capital is the amount available to a company for day-to-day expenses. It’s a measure of a company’s liquidity, efficiency, and financial health, and it’s calculated using a simple formula: “current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in one year)“read more position—proportion varies from industry to industry.

#2 – Quick Ratio

The acid test ratioAcid Test RatioAcid test ratio is a measure of short term liquidity of the firm and is calculated by dividing the summation of the most liquid assets like cash, cash equivalents, marketable securities or short-term investments, and current accounts receivables by the total current liabilities. The ratio is also known as a Quick Ratio.read more is a liquidity metric that analyzes the firms’ short-term paying ability from cash, cash equivalents, inventory, and receivables. It is computed as follows.

Now, the ideal acid test ratio is said to be 1:1. Quick assetsQuick AssetsQuick Assets are assets that are liquid in nature and can be converted into cash easily by liquidating them in the market. Fixed deposits, liquid funds, marketable securities, bank balances, and so on are examples.read more or liquid assets can be encashed within 90 days—cash, cash equivalents, marketable securities, and accounts receivables.

#3 – Cash Ratio

Cash ratioCash RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets.read more or absolute liquidity ratio refers to a financial evaluation of a firm’s immediate paying capacity to meet current liabilities. The formula is as follows:

The cash ratio is considered good if it is 0.5:1 or more. It shows that the company has enough ready cash to cover at least half of its short-term obligations.

#4 – Defensive Interval Ratio

The defensive interval ratioDefensive Interval RatioThe defensive interval ratio evaluates the number of days a company can function without utilizing its non-current assets or outside financial resources. The formula is “Defensive Interval Ratio (DIR) = Current Assets / Average Daily Expenditures.“read more/period is the number of days a company can solely survive on its liquid assets and clear operating expenses.

Here,

It indicates a firm’s operating cash flowOperating Cash FlowCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more.

Liquidity Example

Let us consider a numerical problem to understand the practical application of the concept. Given below is the Balance SheetBalance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more of MNC Ltd. for the year ending in December 2021:

If the company’s annual operating expenses amount to $200000 and the non-cash expenses are worth $17500, determine the firm’s liquidity.

Solution:

Cash Ratio = Cash and Cash Equivalents/Current Liabilities

Cash Ratio = (45000 + 35000) / 40000 = 2:1

Quick Ratio = (Cash and Equivalents + Marketable Securities + Accounts Receivables)/Current Liabilities

Quick Ratio = (45000 + 35000 + 15000 + 20000) / 40000 = 2.875:1

Current Ratio = Current Assets/Current Liabilities

Current Ratio = (45000 + 35000 + 15000 + 10000 + 20000) / (15000 + 25000) = 125000/40000 = 3.125:1

Defensive Interval Ratio = Current Assets/Daily Operational Expenses.

Daily Operational Expenses = (Annual Operating Expenses – Noncash Charges)/365

Daily Operational Expenses = (200000 – 17500) / 365 = $500

Defensive Interval Ratio = 125000 / 500 = 250 days

Interpretation

The cash ratio of MNC Ltd. is 2:1. It means, the company’s cash and cash equivalents are twice that of current liabilities—the firm can easily pay off obligations.A quick ratioQuick RatioThe quick ratio, also known as the acid test ratio, measures the ability of the company to repay the short-term debts with the help of the most liquid assets. It is calculated by adding total cash and equivalents, accounts receivable, and the marketable investments of the company, then dividing it by its total current liabilities.read more of 2.875:1 is again a sign of healthy financials. In the short run, the company is maintaining adequate amounts of liquid assets.A 3.125:1 current ratio signifies that the business’ current assets are three times that of current liabilities—shows cash flow efficiency.Also, the defensive interval period is 250 days—commendable for the smooth functioning of the business.

Importance

Reflects Financial Health: Posesing adequate liquid assets, says a lot about a firm’s competency.Ensures Availability of Sufficient Funds: Firms with ample cash and other current assets meet immediate financial obligations with ease. It also indicates that the firm is backed by cash reserves for emergencies.Improves Credibility: Whenever the company needs funds for its future projects either through equity issues or debts, the investors and the financiers thoroughly study the availability of liquid assets. For investors, this signifies reduced risk levels.Expansion: Since, firms with sufficient working capital and cash reserves have more credibility, they are better placed for business growth or expansion.

Liquidity Management in Business

Liquidity risk is a worst-case scenario where a company is unable to settle its short-term liabilitiesLiabilitiesLiability is a financial obligation as a result of any past event which is a legal binding. Settling of a liability requires an outflow of an economic resource mostly money, and these are shown in the balance of the company.read more with available cash and other liquid assets. It shows that the firm is struggling to meet its ends—reasons could be too much debt or an inability to convert credit salesCredit SalesCredit Sales is a transaction type in which the customers/buyers are allowed to pay up for the bought item later on instead of paying at the exact time of purchase. It gives them the required time to collect money & make the payment. read more into cash.

Running out of liquid assets is a risk encountered by financial institutions and governments as well—due to strict regulations and huge debts. Therefore, every entity requires liquidity management; banks, governments, and businesses alike.

Banks are mandated to maintain excessive liquid assets under the Dodd-Frank Wall Street Reform and Consumer Protection Act, 2010. In the short run, businesses use various tools and techniques to identify their cash requirements—cash flow modeling, cash forecasting, cash concentration, and notional pooling. For managing the amount of liquid assets, managers focus on conversion costsConversion CostsConversion cost is incurred by any manufacturing entity in converting its raw material into finished goods sold in the market and includes labour cost and other applied overheads like factory overheads and administrative overhead. Conversion cost = manufacturing overheads + direct labourread more, conversion time, and the price fluctuations of assets or securities.

Liquidity Meaning Ratios Examples Management Importance