Liquidity is a financial ratio that indicates the extent to which a company can meet its current payment obligations. In this context, a distinction is made between dynamic and static liquidity. The liquidity ratio shows whether there is enough money in cash or in the bank account to meet all short-term financial obligations, such as debts and outstanding bills. If a company can pay these debts without a problem, then the company is liquid. If it cannot, then the company is illiquid or illiquid. In addition to liquidity, the terms profitability and solvency are important measures of a company’s health.
Why is liquidity important?
Liquidity is essential to a company’s financial health and survival. Here are some reasons why liquidity plays a crucial role:
- Meeting obligations: Liquidity enables a company to meet its payment obligations, such as paying suppliers, wages and taxes, in a timely manner. A lack of liquidity can lead to delays in payments, which can damage the company’s reputation.
- Financial stability: Sufficient liquidity gives a company the necessary financial stability. It enables the company to cope with unforeseen circumstances, such as economic recessions or changes in market demand, without running into liquidity problems.
- Seizing opportunities: Liquidity enables companies to seize opportunities as they arise. This can mean, for example, being able to respond quickly to favorable purchasing opportunities or make investments that add value to the business.
Example of liquidity
To positively affect a company’s liquidity, companies may make the decision to close divisions or enter into mergers with other parties. In this process, associated assets are sold or added to other divisions. In such situations, it sometimes happens that investors of organizations or corporations leave the company or get back part of their investment. This situation is called liquidation dividend.
If the Board of Directors announces a dividend to shareholders without sufficient retained earnings or capital accounts to pay the distribution, the company returns a portion of the original investment to shareholders. In other words; if there is not enough money to pay investors a return on their investment, then some of the company’s assets are sold, and the capital released can be distributed back to shareholders.
How do you calculate liquidity?
There are several financial ratios and formulas that can be used to calculate a company’s liquidity. Two commonly used ratios are the current ratio and the quick ratio. Below are the formulas and explanations for both ratios:
- Current Ratio: The current ratio, also known as the working capital ratio, is a measure of a company’s liquidity and indicates its ability to meet its obligations in the short term.
The formula for the current ratio is as follows:
Current Ratio = Current assets / Short-term borrowed capital
Current assets include assets that can be converted to cash or consumed within one year, such as cash, inventories, accounts receivable and short-term investments. Short-term debt includes liabilities that must be paid within one year, such as accounts payable, short-term loans and taxes payable. A current ratio greater than 1 indicates that a company has sufficient cash and cash equivalents to meet its short-term obligations. A ratio below 1 indicates a potential liquidity problem.
- Quick Ratio: The quick ratio, also called the acid-test ratio, is a more conservative measure of a company’s liquidity. It is similar to the current ratio, but excludes inventories because inventories may not be able to be liquidated quickly in an emergency.
The formula for the quick ratio is as follows:
Quick ratio = Current assets (excluding inventories) + Cash and cash equivalents / Current liabilities
By removing inventories from the numerator, the quick ratio gives a more realistic picture of a company’s short-term liquidity. As with the current ratio, a quick ratio greater than 1 indicates that a company has sufficient cash to meet its short-term obligations.
