Liquidity


Liquidity, a business's ability to pay obligations, can be assessed using various ratios, such as the current ratio and the quick ratio. In accounting, liquidity (or accounting liquidity) measures a debtor's ability to pay his debts when they fall due. A standard company balance sheet has three parts: assets, liabilities, and ownership equity.

The main categories of assets are usually listed first and typically in order of liquidity. Money, or cash, is the most liquid asset and can be used immediately to perform economic actions like buying, selling, or paying debt, meeting immediate wants and needs. Next are cash equivalents, short-term investments, inventories, and prepaid expenses.

Liquidity also refers to a business's ability to meet its payment obligations by possessing sufficient liquid assets and such assets themselves. For assets themselves, liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value.


Liquidity Monthly liquidity of an organic vegetable business

Liquidity Monthly liquidity of an organic vegetable business


For a corporation with a published balance sheet, various ratios are used to calculate a measure of liquidity. These include the following:

  • The current ratio is the simplest measure and is calculated by dividing the total current assets by the total current liabilities. A value of over 100% is normal in a non-banking corporation. However, some current assets are more difficult to sell at full value quickly.

  • The quick ratio, calculated by deducting inventories and prepayments from current assets and then dividing by current liabilities, gives a measure of the ability to meet current liabilities from readily sold assets.

  • The operating cash flow ratio can be calculated by dividing the operating cash flow by current liabilities. This indicates the ability to service current debt from current income rather than through asset sales.

  • The liquidity ratio (acid test) is a ratio used to determine a business entity's liquidity. It expresses a company's ability to repay short-term creditors out of its total cash. The liquidity ratio results from dividing the total cash by short-term borrowings. It shows the number of times short-term liabilities are covered by cash. If the value is greater than 1.00, it means fully covered. The formula is the following: LR = liquid assets / short-term liabilities.

Key Points

  • Liquidity refers to a business's ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to such assets themselves. For assets, liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value.

  • A standard company balance sheet has three parts: assets, liabilities and ownership equity. The main categories of assets are usually listed first, typically in order of liquidity.

  • For a corporation with a published balance sheet there are various ratios used to calculate a measure of liquidity, namely the current ratio, the quick ratio, the operating cash flow ratio, and the liquidity ratio (acid test).

Terms

  • Liquidity Ratio – measurement of the availability of cash to pay debt

  • Cash Equivalents – A deferred expense or prepayment, prepaid expense, plural often prepaids, is an asset representing cash paid out to a counterpart for goods or services to be received in a later accounting period.

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