Liquidity is entity’s ability to pay its current liabilities using current assets instead of arranging finance through external sources like overdrafts or short-term loans.
To meet short term obligations just using internal resources, entity’s current assets must be:
- holding enough value or worth
- readily convertible to cash
In short, entity’s ability to meet short term obligations is dependent on quantity and quality (ability to readily convert in cash) of assets.
If entity’s current assets are less than current liabilities then entity will have to rely on external sources. Similarly even if entity has current assets more than current liabilities but they can’t be converted into cash before liabilities fall due again entity is facing liquidity problem.
Liquidity ratios help analysts measure entity’s ability to meet its current obligations. Using liquidity ratios one can assess if management was utilizing the resources efficiently at its disposal and how effectively it was able to align the assets with liabilities.
Liquidity level required for each entity or entity’s of particular industry depends on number of factors and one can assess the liquidity position of the entity only at a particular day of the period considering the factors like how much cash entity currently holds, future commitments, anticipated risks, any contingencies arising or have a potential of becoming a liability, rate of inflation, market structure and position of entity in the market (e.g. market share), credit terms with customers and suppliers, nature of business and size of entity etc.
As compared to small scale entities, large entities can coupe liquidity problems relatively easily. Reason is that large entities have access to sources of finance and thus can arrange funds if needed most of the time.
Analysts use following ratios to measure the liquidity of entity at varying degree of assets in terms of liquidity:
- Current ratio
- Quick ratio or acid test ratio
- Cash ratio
In addition to above mentioned ratios financial analysts also uses the following techniques to better assess entity’s liquidity position:
- Defensive interval ratio
- Cash conversion cycle
Liquidity ratios formulas
|Current ratio||=||Current assets||/||Current liabilties|
|Quick ratio||=||Receivables + Short term investments + Cash||/||Current liabilities|
|Cash ratio||=||Short term investments + Cash||/||Current liabilities|
|Defensive interval ratio||=||Receivables + Short term investments + Cash||/||Daily operational cash requirement|
|Cash conversion cycle||=||Inventory turnover period + Receivable turnover period – Payables turnover period|