Liquidity

In simpler terms; liquidity refers to a company’s ability to meet its short-term obligations using its available assets.

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Key aspects of liquidity:

Current Assets.

These are assets that can be converted into cash within a year, such as:

• Cash and cash equivalents (e.g., bank accounts, short-term investments)

• Accounts receivable (money owed by customers)

• Inventory (goods available for sale)

Current Liabilities.

These are debts or obligations that the company needs to pay within a year, including:

• Accounts payable (money owed to suppliers)

• Short-term loans

• Accrued expenses (e.g., wages, taxes)

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Liquidity Ratios.

To assess a company’s liquidity, there are key ratios that compare current assets to current liabilities:

Current Ratio.

This ratio indicates how well a company can cover its short-term obligations using its current assets. A ratio above 1 suggests the company can meet its liabilities, while a ratio below 1 might indicate liquidity issues.

Current Ratio = Current Assets / Current Liabilities

Quick Ratio (Acid-Test Ratio).

This is a more stringent measure than the current ratio, as it excludes inventory, which might not be easily converted into cash quickly. A ratio above 1 generally signals good liquidity.

Quick Ratio = ( Current Assets – Inventory ) / Current Liabilities

Cash Ratio.

The most conservative liquidity ratio, it only considers cash and cash equivalents. It shows the company’s ability to pay off its liabilities with cash on hand.

Cash Ratio = Cash and Cash Equivalents / Current Liabilities 

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Why is liquidity important?

• Short-Term Solvency. Can a company can meet its short-term obligations? Such as paying suppliers and employees? Without needing to raise funds or sell long-term assets.

• Financial Stability. Companies with strong liquidity are more likely to survive economic downturns or financial stress.

• Operational Flexibility. Good liquidity allows a company to take advantage of opportunities or deal with unexpected challenges.