In accounting, there is a list of terms used widely during the time of analyzing the company's financial statements. The analysis is made to study the relationship among the various financial factors in a business.
As a result, the company goes under process to determine and interpret the relationship between the items of financial statements. It can provide a meaningful understanding of the performance and financial position of the enterprise.
One such measure that financial analysts and accountants look forward to understanding and analyzing is to meet short term obligations of the company. Here, Liquidity comes into the picture!
In this article, we will be covering Liquidity, its importance, and measurability.
The article shares about:
• What is Liquidity?
• Why is Liquidity important?
• What are measures of Liquidity?
• What is the order of Market liquidity?
• What are the types of Accounting Liquidity ratios?
• Example to understand liquidity ratios
What is Liquidity?
In financial markets, Liquidity is termed as the degree to which a security can be sold or purchased in the market at a price reflecting the current value.
It means how well and quickly an investment can be bought or sold in the market without negatively impacting the price.
It is said that the more the Liquidity of an investment, the more it can be sold and vice versa. For example, cash is the most liquid asset because it can convert easily and quickly compared to other investments.
On the other hand, intangible assets like buildings or machinery are less liquid in terms of the liquidity spectrum.
In accounting and financial analysis, a company's Liquidity depicts how easily the company is able to meet its short-term financial obligations.
Why is Liquidity important?
Liquidity is a vital factor for companies looking forward to planning their investment ahead of the future. In addition, Liquidity also ensures that companies' current needs align with their long-term investment plan.
Let's take a look at a two significant reasons highlighting the importance of Liquidity in the company:
- A balance of liquid and non-liquid securities
- Provisions for cash reserves
1. A balance of liquid and non-liquid securities
Every company aims to secure a balance between owning liquid assets and non-liquid assets. For example, a company should hold ideal liquid assets like mutual funds bonds, stocks, and non-liquid assets like investments and premium securities to strike a balance between the two.
This will help them allocate the resources and assist in utilizing them well.
2. Provisions for cash reserves
Emergencies can knock on the door at any moment!
Even if a company invests a higher amount in the non-liquid asset, it is still advisable for companies to keep a small amount aside that can be used for emergency purposes.
There is no restriction on limitation to set the ideal amount for reserves, but it should be that much that can cover the three-month income as cash reserves.
Cash Reserves help you to prepare for the future.
Since a company's Liquidity is linked with investment, it is always crucial for the companies to understand the liquidity levels and get going with their financial plans.
What are measures of Liquidity?
Liquidity can be measured in two forms: one is market liquidity, and the other is accounting liquidity.
Let's take a look at these measures of liquidity insights in detail:
1. Market liquidity
Market liquidity refers to the extent to which a market allows assets to be bought and sold at stable prices. Here, the market includes the country's stock market or the city's real estate market.
In simple words, market liquidity refers to how quickly an investment can be sold without impacting the current price.
The Stock Market is characterized by higher market liquidity because of the high volume of trade dominated by selling.
For example, if the buyer offers per share and the seller is willing to accept that price per share, it is most likely that the securities will convert.
On the other hand, the markets for real estate are usually less liquid than compared to the stock market. It is because of the more minor and rare intended purposes.
For example, if the buyer offers sale value and the seller is not willing to accept, then the chances of coming together at a price are less, which is why the market becomes less liquid.
2. Accounting Liquidity
Accounting liquidity refers to a measure to understand the level of an individual or a company to meet its financial obligations with liquid assets available to them. In simple words, it refers to measuring the ability of a company to meet its financial obligations concerning the company's short-term debts.
Accounting liquidity is also termed as Financial Liquidity.
Unlike marketing liquidity, there are a number of ratios that measure accounting liquidity. Through these ratios, the users of financial statements like analysts and investors use to identify the liquidity position of a company.
What is the order of Market liquidity?
Since we are clear about the concept of market liquidity, now is the time to understand the order and ranking of the securities coming under market liquidity.
Following is the list of rankings comprising common investments that are ranked in terms of how quickly and easily they can be converted into cash.
The order might vary from company to company, depending upon the situations and circ*mstances.
The standard order for the market liquidity assets are as follows:
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As you can observe,
• cash is regarded as one of the most liquid assets because it is already converted into cash.
• Then comes in foreign currency and bonds that are most likely to be converted within 2 to 3 days
• Lastly, the real estate and following items take much longer to convert into cash, say between 10-11 months, or even they can stretch for yours too.
What are the types of Accounting Liquidity ratios?
Just like market liquidity discusses the order of the securities, accounting Liquidity discusses the types of ratios used to measure the company's Liquidity.
In accounting liquidity, the company refers to the balance sheet items, typically listed from the most liquid to the least liquid asset. The assets are subdivided into current and noncurrent assets, consisting of particulars at the bottom.
Based on the concept, there are three common types of accounting liquidity ratios that are calculated using formulas:
Let's take a look at the three types of accounting liquidity ratios:
- Current Ratio
- Quick Ratio
- Cash Ratio
1. Current Ratio
The Current Ratio is a liquidity ratio that establishes a relationship between current assets and current liabilities. The current Ratio indicates whether an enterprise will meet its practical short-term obligations when they become due for payment.
The Current Ratio is also termed as the measurement of the enterprise's financial health.
The computation of the Current Ratio is based on the formula:
Current Ratio = Current Assets/ Current Liabilities |
The standard and acceptable current Ratio differs from industry to industry. But the ideal preferred accepted standard of current Ratio is 2:1,
That is, the current assets should be twice the current liabilities.
2. Quick Ratio
The quick ratio is a liquidity ratio that establishes a relationship between liquid assets and current liabilities.
The quick ratio is also known as the liquid Ratio or acid-test Ratio, which indicates the short-term paying capacity of the enterprise. This is the reason why the Ratio includes the liquid assets exclusively.
One thing to note is that while calculating the acid test ratio, the current assets like inventories and prepaid expenses are excluded from liquid assets because it takes a longer time to get converted into cash.
Hence, the computation of the Acid-test ratio is based on the formula:
Acid Test Ratio/Quick Ratio = Liquid Assets or Quick Assets/ Current Liabilities Or Acid Test Ratio/Quick Ratio = Current Assets- Inventories- Prepaid Expenses/ Current Liabilities |
Just like the Current Ratio, the ideal and accepted standard to maintain a quick Ratio is 1:1,
That is, the quick assets and current liability both have equal value.
3. Cash Ratio
The quick Ratio is the liquidity ratio that establishes a relationship between cash and cash equivalents and current liabilities. It only includes the assets strictly in the form of cash or cash equivalents and excludes account receivables, inventories, and other current assets.
The cash ratio indicates the company's ability to stay solvent even in the case of emergencies and worst-case scenarios.
The computation of cash ratio is based on the formula:
Cash Ratio = Cash and Cash Equivalents/ Current Liabilities |
All the three types of ratios are analyzed by the users of financial statements specially banks, investors and financial institutions for different purposes.
Example to understand liquidity ratios
Since we have understood the concept of the three types of liquidity ratios, let's take a look at the example to understand the liquidity ratios in-depth.
Following is the example of a balance sheet, which displays the assets and liabilities in order of its liquidity.
Based on that, will compute the liquidity ratios and see what the results comes in:
As you can witness, the balance sheet of the company is separated into two categories one is current assets and the other is non-current assets, along with stating the liabilities and shareholders fund.
Based on the information, following are the computation of all the liquidity ratios discussed above:
Current Ratio
Current Ratio = Current Assets/ Current Liabilities
where
Current Assets = Inventories +Trade Receivables Cash & Cash Equivalents + Prepaid Expense
&
Current Liabilities = Trade Payables + Short Term Provisions
i.e
Current Assets= 1,20,000+90,000+22,800+7200= 2,40,000
Current Liabilities = 2,34,000+6,000 = 2,40,000
Based on Formula,
Current Ratio = 2,40,000/2,40,000
= 1:1
Therefore, the current ratio for the company is 1:1
Quick Ratio
Quick ratio = Liquid Assets/ Current Liabilities
where
Liquid Assets = Trade Receivables + Cash & Cash Equivalents
&
Current Liabilities = Trade Payables + Short Term Provisions
i.e.
Liquid Assets = 90,000+ 22,800 = 1,12,800
Current Liabilities= 2,34,000+6,000 = 2,40,000
Based on Formula,
Liquid Ratio = 1,12,800/ 2,40,000
= 0.47:1
Therefore, the liquidity ratio of the company is 0.47:1
Cash Ratio
Cash Ratio = Cash and Cash Equivalents/ Current Liabilities
Where,
Cash & Cash Equivalents = 22,800
&
Current Liabilities = Trade Payables + Short Term Provisions
i.e.
2,34,000+6,000 = 2,40,000
Based on formula,
Cash Ratio = 22,800/2,40,000
0.095
Therefore, the cash ratio of the company is 0.095:1
This is how to identify and calculate the accounting ratios of the company.
Key Takeaways
In this article, we covered the concept of liquidity, its importance and computation in detail.
Let's take a look at the key takeaways of the article:
- Liquidity is termed as the degree to which a security can be sold or purchased in the market at a price reflecting the current value.
- Liquidity is termed as a vital factor for companies who are looking forward to planning their investment ahead of the future.
- There are two significant reasons that highlights the importance of liquidity in the company
- First reason is the balance of liquid and non liquid securities and second is provisions for cash reserves.
- Liquidity can be measured in two forms one is market liquidity and other is accounting liquidity.
- Market liquidity refers to an extent in which a market allows assets to be bought or sold at stable prices.
- Accounting liquidity refers to a measure to understand the level of a company to meet its financial obligations.
- There is a clear order and ranking of the securities coming under market liquidity.
- It starts from the most liquid form that is cash to the least liquid form which is real estate.
- There are typical three types of accounting liquidity ratios that measures the company's liquidity
- The types include current ratio, quick ratio and cash ratio
- The computation of ratios are based on a series of formulas signifying different purposes and objectives
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