Liquidity is converting an asset into cash without affecting its price. Liquidity is important in finance as it allows a company or individual to meet short-term obligations without having to sell long-term investments or take on debt.
Content Outline
Key Takeaways for Liquidity
Liquidity measures how fast assets can be converted into cash.
Cash and cash equivalents are the most liquid assets.
Liquidity helps individuals and companies meet their immediate needs.
Liquidity ratios like the current ratio and quick ratio check a company’s liquidity.
Why Is Liquidity Important?
Liquidity is important for:
- Meeting Short-Term Obligations: Businesses need liquidity to pay expenses like payroll, loan payments and rent. If a company doesn’t have enough liquid assets it may have to sell long-term investments at a loss or borrow money.
- Financial Health: High liquidity means financial health. Companies with enough liquid assets are more robust in downturns and can better manage unexpected expenses.
- Investment Opportunities: Having liquid assets allows businesses and individuals to quickly take advantage of investment opportunities without having to sell less liquid, long-term assets.
- Creditworthiness: Companies with good liquidity have better credit ratings and can get loans at better rates.
How to Measure Liquidity
Liquidity can be measured by using these financial ratios:
1. Current Ratio
The current ratio compares a company’s current assets to its current liabilities.
Formula:
Current Ratio = Current Assets / Current Liabilities
A current ratio above 1 means a company has more current assets than liabilities which is good for liquidity.
2 .Quick Ratio (Acid-Test Ratio)
This ratio excludes inventory from current assets as inventory may take longer to convert into cash.
Formula:
Quick Ratio = (Current Assets – Inventory) / Current Liabilities
This gives a more conservative measure of liquidity.
3. Cash Ratio
The cash ratio focuses only on cash and cash equivalents relative to current liabilities.
Formula:
Cash Ratio = Cash + Cash Equivalents / Current Liabilities
It represents the most liquid assets a company has to meet its obligations.
Liquidity Example
A company has the following balance sheet:
- Current Assets: $500,000 (cash, receivables and inventory)
- Inventory: $150,000
- Current Liabilities: $300,000
Current Ratio
Current Ratio = 500,000 / 300,000 = 1.67
The company has $1.67 of current assets for every $1 of current liabilities, good liquidity.
Quick Ratio
Quick Ratio = (500,000 – 150,000) / 300,000 = 350,000 / 300,000 = 1.17
Even without inventory the company has $1.17 of highly liquid assets to cover each dollar of liability.
This demonstrates the company’s ability to cover short-term obligations without relying on less liquid assets like inventory.