Question

6 What is liquidity? Identify and discuss two ways to measure a company's liquidity.

Answer 1

Answer-6-

Liquidity measures a firm's ability to pay operating expenses and other short-term, or current, liabilities. Because current liabilities, which are debts that must be paid or obligations that must be fulfilled, within 1 year, are paid out of current assets, which are received as cash or otherwise used within 1 year, liquidity measures are calculated using current assets and current liabilities.

Current assets include:

• cash and cash equivalents
• short-term investments
• account receivables
• inventory
• prepaid expenses

Current liabilities include:

• accounts payable
• short-term debt
• current interest payments for long-term debt
• salaries
• taxes

A low liquidity measure would indicate either that the company is having financial problems.a fairly high liquidity ratio is good. However, it shouldn't be too high, because excess funds incur an opportunity cost and can probably be invested for a higher return.

Two ways to measure a company's liquidity:-

net working capital and the current ratio,

1-

Net working capital is what remains after subtracting current liabilities from current assets; hence, it is money to run the business.

Net Working Capital Formula

Net Working Capital

=

Current Assets

–

Current Liabilities

2-

The current ratio (aka working capital ratio) is the ratio of current assets divided by current liabilities.

Current Ratio Formula

		Current Assets
Current Ratio	=
		Current Liabilities

Answer-7-Solvency refers to an enterprise's capacity to meet its long-term financial commitments.

Two ways to measure a company's liquidity:-

1-Debt-to-Equity (D/E)

2-Debt-to-Assets

1-

Debt-to-Equity (D/E)

Debt to equity = Total debt / Total equity

This ratio indicates the degree of financial leverage being used by the business and includes both short-term and long-term debt.

2-

Debt-to-Assets

Debt to assets = Total debt / Total assets

Another leverage measure, this ratio quantifies the percentage of a company's assets that have been financed with debt (short-term and long-term)