BUS103: Introduction to Financial Accounting

Liquidity, a business's ability to pay obligations, can be assessed using various ratios: current ratio, quick ratio, etc.

Learning Objective

• Calculate a company's liquidity using a variety of methods.

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

• 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.
• liquidity ratio
  measurement of the availability of cash to pay debt
  

In accounting, liquidity (or accounting liquidity) is a measure of the ability of a debtor 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 both to a business's ability to meet its payment obligations, in terms of possessing sufficient liquid assets, and to 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

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

• The current ratio, which 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 in a hurry.
• The quick ratio, which is calculated by deducting inventories and prepayments from current assets and then dividing by current liabilities--this gives a measure of the ability to meet current liabilities from assets that can be readily sold.
• 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 the liquidity of a business entity. Liquidity ratio expresses a company's ability to repay short-term creditors out of its total cash. The liquidity ratio is the result of 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.