How do you measure a company's liquidity?

20.03.2020
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What is Liquidity?

The measure of ability with which assets can be easily sold or bought is known as liquidity. The assets which fall under liquidity are known as liquid assets. Cash is considered to be the most liquid asset that one can have. Other than cash, saving accounts, and checkable accounts are also liquid assets. All the types of assets like Real Estate or Equities come under different levels on the liquidity spectrum.

Liquidity of a company

When we use the term “Liquidity” in business, it means the ability of an organization to turn its assets like receivables, investments, and inventory into cash. Liquidity is important for a company if it wants to borrow money. The potential of a company is determined by investors and creditors through the liquidity ratio to make sure that the company is strong, stable and has adequate assets in case of difficult times. In an off-season, when a company needs to purchase inventory, maintain payroll or pay off the creditors, it looks for credit or financing. Many small organizations consider taking loans a risk. But there are methods through which it can be made sure that the company is able to pay for the loans comfortably.

Measurement of Liquidity

We have various types of measurements for liquidity such as Current Ratio, Quick Ratio, and Net Working Capital. All these measurements have different formulas by which they are calculated.

Current Ratio
The current ratio is a type of liquidity measure that shows how efficient a company is to pay its current liabilities. It provides a better idea about the potential of a company to pay current liabilities regardless of its size. The current ratio is the total current assets divided by the total current liabilities. It is the most used liquidity ratio formula. According to this formula:

Total current assets = Cash in banks + Accounts receivable + Inventories
Total current liabilities = Trade payables + Current maturities of long term debt + Accrued expenses + Short term notes

Current ratio = Current assets/Current liabilities

A current ratio above 2:1 is considered as a comfortable level of liquidity by financial analysts, business managers, and lenders. The reason this ratio is believed to be good is that sometimes it takes more time to convert inventory to sales to receivables and lastly to cash. Selling inventory is quite difficult as it doesn’t always sell according to expectations.

Quick Ratio
The quick ratio is a more rigid measure of short-term liquidity as compared to current ratio and it is also called the acid-test ratio and quick asset ratio. It is similar to the current ratio but the value of inventory and prepaid expenses are not present in the numerator. The quick ratio is the sum of cash in banks added to accounts receivable divided by the sum of all current liabilities.

Quick ratio = (Cash in banks + Accounts receivable)/Sum of current liabilities

The quick ratio is considered to be acceptable if it is above 1.5:1

Net Working Capital
Net Working capital is another financial metric used to measure liquidity. It is used to keep a business going and paying out current liabilities along with the operating expenses. This metric is quite different from the previous ones as it is not a ratio but an actual dollar amount. The amount is calculated by subtracting current liabilities from the current assets.

Net Working capital = current assets – current liabilities

The Net Working capital should always grow in a proportion similar to the growth of sales and the total assets of a business. It is considered important as the figure is needed to always go up.

Although a variety of financial measures are used by business managers to track business performance, liquidity ratios are one of the most crucial. Any decline in any of the liquidity ratios gives a warning to the manager that if the required actions are not taken the situation may get worse.

What are liquid assets?

The assets which fall under liquidity are known as liquid assets. Cash is considered to be the most liquid asset that one can have.

What liquid assets are there other than cash?

Other than cash, saving accounts, and checkable accounts are also liquid assets. All the types of assets like Real Estate or Equities come under different levels on the liquidity spectrum.

What does liquidity represent in business?

When we use the term “Liquidity” in business, it means the ability of an organization to turn its assets like receivables, investments, and inventory into cash. Liquidity is important for a company if it wants to borrow money.

How is potential of a company determined by investors?

The potential of a company is determined by investors and creditors through the liquidity ratio to make sure that the company is strong, stable and has adequate assets in case of difficult times.

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