Liquidity

Liquidity is the ability to quickly convert an asset into cash at its fair market value. The easier it is to exchange an item for money, the more liquid it is.

Take, for example, machine tools in a factory — they will have low liquidity, since it is unlikely that they will be able to sell them quickly and at a realistic value. Money has perfect liquidity — there is no point in changing it for itself. In these examples, both machines and money are assets. An asset is any resource with economic value.

The term “liquidity” applies not only to an asset, but also, in general, to a company.

What is Liquidity Used For?

Liquidity is assessed when it is necessary to understand the level of solvency of the company to which they belong and whether it will actually be able to repay its debts.

For example, a company has a lot of money in bank accounts, and goods are stored in warehouses that can be easily sold. It is easier for such a company to get an approved loan from a bank, since it will be able to repay it when due. But if the company’s assets include dilapidated production facilities and its accounts are empty, then if the company goes bankrupt, it will be difficult for creditors to get their money back.

Liquidity Ratios

In financial analysis, three indicators are used to evaluate the company’s performance:

Current Ratio reflects the ability of a business to repay short-term debts within one year.

The formula for calculating this coefficient is:

Current Ratio: CR = CA / CL, where: CA — current assets; CL‌ — current liabilities.

The higher the current liquidity of the company, the higher the probability of paying off debts on time. Normal liquidity is from 1.5 to 2. CR below 1.5 increases the risk of failure to repay short-term loans (up to a year) and other obligations. High values are also not a very good predictive marker, as they can reflect a situation when a large number of finished products are stored in warehouses, but for some reason they are not sold on time.

Cash Ratio reflects the solvency of the business at the current time.

The indicators of the Cash Ratio are calculated using the formula:

Cash Ratio = (Cash + Short-term Investments) / CL, where: Cash — cash and cash equivalents; Short-term Investments — marketable securities; CL — current liabilities.

Accordingly, the larger the Cash Ratio, the more liquid assets the company has to pay off short-term liabilities faster. The optimal values range from 0.2 to 0.5. If the indicator is low, then the company cannot repay its debts; if the figures are higher, we understand that it does not use more than 50% of borrowed funds, but accumulates them in accounts.

Quick Ratio demonstrates the extent to which current liabilities can be covered by liquid assets (excluding inventories).

It is calculated using the formula:

QR = (CA – I) / CL, where: CA — current assets; I — inventories; CL — current liabilities.

This indicator is often used by banks when evaluating a potential borrower, because they need to somehow assess whether to approve or deny a loan. The optimal QR value is from 0.8 to 1. With a low indicator, there is a risk that the company will not be able to repay its debts on time. On the contrary, if the indicator is very high, then excessive current assets are tied up, which could have been used to generate profit.

Attention! The range of all ratios is highly indicative. It should be evaluated individually for each company; much depends on the current assets and short-term obligations.

How to Increase Liquidity

To improve liquidity, companies can increase working capital, profitability, and reduce debt. It is also possible to reduce accounts receivable.

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