Liquidity and Liquidity Ratios

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Liquidity

In investing, liquidity is the ability of an entity to convert assets into cash, or how quickly you can get your hands on some money.

In business or accounting, liquidity is the ability of a business to pay its short-term obligations and debts when they are due and it is usually expressed, the current ratio, as a liquidity ratio or percentage of liabilities. The liquidity of a business firm is usually of particular interest to its short-term creditors since the liquidity of the firm measures its ability to pay those creditors.

Generally, the higher the value of the liquidity ratio, the greater the margin of safety a company possesses in its ability to pay its bills.

4 Liquidity Ratios

Several financial ratios measure the liquidity of the firm, with all information coming from your balance sheet. Those ratios are the current ratio, the quick ratio or acid test, and the interval measure or the burn rate.

  1. The simplest is the current ratio. It is the percentage of total current assets divided by the total current liabilities. It borrows from the investing definition because it assumes all the assets can be converted instantly into cash, which is often not the case. A value of over 100% is not unusual when calculating the current ratio.
  2. The quick ratio, or acid test, measures a business' ability to meet current liabilities from assets than can be readily sold (though it is preferable to meet these obligations from cash flow). It deducts inventories and prepayments from current assets, then divides them by current liabilities.
  1. Operating cash flow ratio is the ability of the company to satisfy current debt from current income, rather than asset sales. It is a two-step calculation. Operating cash flow is calculated by adding non-cash expenses (usually depreciation expenses) and changes in working capital. The ratio is achieved by dividing operating cash flow by current liabilities.
  1. The interval measure, also known as the burn rate, looks at the number of days a company can operate using only cash on hand. It is similar to the current ratio and quick ratio in that it is concerned with how easily a company can satisfy its current debt obligations. It is, however, sometimes preferred to the quick and current ratios because it provides an approximation of the actual number of days, where the other ratios provide a value that indicates the ability and ease of making the payments. The interval measure is calculated by dividing quick assets, or those assets then can be immediately converted into cash, by daily operating expenses.

Also useful is net working capital, or working capital, is the total aggregate amount of all current assets less all current liabilities, measuring the short-term liquidity of a business. It's also an indicator of the ability of the company's management to utilize assets in an efficient manner

A Concern

While some business owners will consider all assets in calculating these ratios, some analysts will only use the most liquid assets, as they are looking at a worst-case scenario.

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