Liquidity

Key Takeaways

1. Liquidity means how quickly a business can transform its assets into money to pay its short term liabilities.
2. Important Liquidity Ratio: current ratio, acid-test ratio, and cash ratio.

Liquidity in a financial market is the participants’ ability to easily trade the securities in the market without having to incur a substantial bid ask spread, trading commissions, etc.

What does liquidity mean in business?

Liquidity is a tool to measure a company’s ability to pay short term liabilities by quickly converting assets or near-cash securities into cash. Businesses typically pay their financial liabilities by using immediate assets. It means how quickly a business can transform its assets into money to pay its short term financial obligations.

Liquidity Ratio

Liquidity is the capacity of the firm to meet its financial obligations in a short duration, usually one year. Liquidity ratios are traditionally based on the relationship between current assets (the source for meeting short – term obligations) and current liabilities.

Important Liquidity Ratio: current ratio, acid-test ratio, and cash ratio.

Current Ratio: a prevalent ratio, the current ratio defined as:

Current ratio = (Current Assets)/(Current Liabilities)

Current assets consist of cash, current investments, trade receivables, inventories (stocks), loans, and advances. Current liabilities are the liabilities that are expected to mature in the next twelve months; it can be the loan, which is due or any current liabilities and provision.

Acid-Test Ratio / Quick Ratio: Quick Ratio indicates the company’s ability/capacity to pay all its current liabilities by using its near cash or quick assets, which can be quickly converted to cash.

Quick Ratio = (Liquid Assets)/(Current Liabilities)

Current Ratio and quick ratio, both ratios indicate higher liquidity and more excellent financial health.

Cash Ratio: Cash, bank balances are the most liquid assets of the company.

Cash Ratio = (Cash and Bank balances+Current Investments)/(Current Liabilities)

What are some examples of liquidity?

Cash and stocks have high liquidity because they are easy to access and trade. Land and real estate are generally less liquid, and it takes a long time to sell it and get money out of it.

Why is liquidity important?

Liquidity is the ability to pay debts when they are due. Liquidity is an indicator of the financial health of a business. Every organization or an entity that is profitable will find itself in a position of bankruptcy, and it fails to meet its financial obligations to short term creditors.