Liquidity may take on a different meaning depending on the context, but it always has to do with one thing: cash, or ready money.
Liquidity refers to the amount of money that is promptly available to meet debts or to use for investment. It indicates the levels of cash available and how quickly a financial asset or security can be converted into cash without losing significant value. In other words, how long it takes to sell.
Liquidity is important because it shows how flexible a company is in meeting its financial obligations and unexpected costs. It also applies to the average individual as well. The greater their liquid assets (cash savings and investment portfolio) compared to their debts, the better their financial situation.
Why Liquidity is Important?
The higher their liquidity, the better the financial health of a business or a person is. For example, say a company had a monthly loan payment of Rs.5,000. Its sales are doing well and the company is realizing profits. It has no issues in meeting its Rs.5,000 monthly obligation.
Now say the economy suffered a sudden economic downturn. Demand for the business’s products has vanished so, therefore, it is not bringing in revenue and making profits; however, it still has to meet its Rs.5,000 monthly loan bill.
Unfortunately, the company only has Rs.3,000 of cash on hand and no liquid assets to quickly sell for cash. It will default on its loan within one month. Now if the company had Rs.10,000 in cash and other liquid assets worth Rs.15,000 that it could sell in a few days for cash, it would be able to meet its debt obligations for many months to come, hopefully until the economy rebounds.
The same holds for human beings. The more savings an individual has the easier it is for them to pay their debts, such as their mortgage, car loan, or credit card bills. This particularly rings true if the individual loses their job and immediate source of new income. The more cash they have on hand and more liquid assets they can sell for cash, the easier it will be for them to continue to make their debt payments while they look for a new job.
Items on a company’s balance sheet are typically listed from the most to the least liquid. Therefore, cash is always listed at the top of the asset section, while other types of assets, such as Property, Plant & Equipment (PP&E), are listed last.
Current ratio & Quick Ratio-
The quick ratio, aka the acid test ratio, also measures current assets against current liabilities. However, in its calculation of current assets; it only uses the most liquid assets: cash, marketable securities, and accounts receivable. It does not include inventory, which the current ratio does, as inventory cannot be sold as quickly as the other assets.
There are actually two formulas for the quick ratio:
Quick ratio= (cash + marketable securities + accounts receivable) / current liabilities
Current Ratio= Cash + marketable securities + accounts receivable+ inventory/ current liabilities
Cash Ratio Basics
The cash ratio is an even more stringent ratio than the quick ratio. It compares only cash to current liabilities. If a company can meet its financial obligations through just cash without the need to sell any other assets, it is an extremely strong financial position.
The cash ratio is calculated as:
Cash ratio= Cash / Current liabilities