Question

What is meant by the term Liquidity and what are the three measures computed to assess a business' liquidity positions?

Answer 1

Liquidity is a company’s ability to raise cash when it needs it.

There are two major determinants of a company’s liquidity position. The first is its ability to convert assets to cash to pay its current liabilities (short-term liquidity). The second is its debt capacity. Debt capacity is a company’s ability to service its current debt load as well as its ability to raise cash through new debt.

Short-term liquidity is calculated from the following measures and ratios:

• Working capital
• Acid-test ratio
• Current ratio
• Payables turnover
• Average collection period
• Inventory turnover

Debt capacity is calculated from these ratios:

• Debt service coverage ratio
• Debt-to-total assets ratio
• Debt-to-equity ratio

All nine measures need to be evaluated together to get the full picture of a business’s ability to raise cash. A business would also want to benchmark each measure against those of other companies in its industry to get a complete understanding of its financial health.

Liquidity for companies typically refers to a company's ability to use its current assets to meet its current or short-term liabilities. A company is also measured by the amount of cash it generates above and beyond its liabilities. The cash left over that a company has to expand its business and pay shareholders via dividends is referred to as cash flow. Although, this article won't delve into the merits of cash flow, having operating cash is vital for a company both in the short-term and for long-term expansion.

Below are three common ratios used to measure a company's liquidity or how well a company can liquidate its assets to meet its current obligations.

The current ratio (also known as working capital ratio) measures the liquidity of a company and is calculated by dividing its current assets by its current liabilities. The term current refers to short-term assets or liabilities that are consumed (assets) and paid off (liabilities) is less than one year. The current ratio is used to provide a company's ability to pay back its liabilities (debt and accounts payable) with its assets (cash, marketable securities, inventory, and accounts receivable). Of course, industry standards vary, but a company should ideally have a ratio greater than 1, meaning they have more current assets to current liabilities. However, it's important to compare ratios to similar companies within the same industry for an accurate comparison.

The quick ratio, sometimes called the acid-test ratio, is identical to the current ratio, except the ratio excludes inventory. Inventory is removed because it is the most difficult to convert to cash when compared to the other current assets like cash, short-term investments, and accounts receivable. In other words, inventory is not as liquid as the other current assets. A ratio value of greater than one is typically considered good from a liquidity standpoint, but this is industry dependent.

The operating cash flow ratio measures how well current liabilities are covered by the cash flow generated from a company's operations. The operating cash flow ratio is a measure of short-term liquidity by calculating the number of times a company can pay down its current debts with cash generated in the same period. The ratio is calculated by dividing the operating cash flow by the current liabilities. A higher number is better since it means a company can cover its current liabilities more times. An increasing operating cash flow ratio is a sign of financial health, while those companies with declining ratios may have liquidity issues in the short-term.