Liquidity is an important factor in the sustainability of a business. Of course, a company must have sufficient funds to meet its financial obligations, aka debt. Therefore, we certainly need to have cash. However, too much cash will reduce opportunities to invest and support company growth.
In this regard, we need to understand the meaning of liquidity, because measuring liquidity can help to find the right balance and monitor the financial “health” of a company. As a result, our business can be helped and grow further.
Not only those basic things, liquidity is also important when we apply for funding or a loan. This is because banks and investors will pay close attention to liquidity ratios when considering a company’s ability to pay off its debts.
This is certainly a good reason for us to immediately study liquidity, starting from the basics. But before that, what is the theoretical meaning of liquidity? Let’s look at the discussion below regarding the meaning of liquidity and examples and its role in investment!
Understanding Liquidity
The general definition of liquidity actually has two meanings. In a company, liquidity is an important factor in determining its condition or sustainability. Therefore, many business actors use liquidity as a benchmark or reference to assess the company’s ability to finance the company’s operational needs or activities.
As we know, the definition of liquidity in accounting and financial analysis is a measure of how easy and possible it is for a company to fulfill short-term obligations, such as business debts, dividends, taxes, and others, using current assets.
For example, we may see that there is still enough cash to cover current and future bills as we expect. Or, we may need to leverage investments and other assets that can be converted into cash. The easier it is to convert an asset into cash, the more liquid the asset is.
For example, there is a shop that sells collectible stamps. These stores may hold their inventory for the right buyers to get the best price, which means the stamps are not very liquid. However, if the same stamp store has stocks or bonds, both can be sold quickly so the investment is considered liquid.
In financial markets, this term refers to how quickly an investment can be sold without having a negative impact on its price. If we know that an investment is more liquid, it means that the investment can be sold more quickly, and vice versa.
With liquidity, it is possible for assets that are considered more liquid to be traded at higher prices because of the profits they bring. Meanwhile, illiquid assets are traded at lower prices.
Please note, companies use assets to run their business, including producing goods or creating value in other ways. Assets can include things like equipment or intellectual property. Meanwhile, inventory or products that a company sells to generate income are usually considered current assets because they will usually be sold within one year.
For an asset to be considered liquid, it needs to be in an established market with many interested buyers. Moreover, the asset must also have the ability to transfer ownership easily and quickly.
The information we need to check liquidity can be found on a company’s balance sheet. The reason is, assets are usually listed in order of how quickly they can be converted into cash. So, at the top of the balance sheet is cash, the most liquid asset.
In this balance sheet, our company’s obligations or debts are also listed. Obligations are listed in the order of when they are due. Bills that must be paid first are listed at the top.
Comparing short-term liabilities with cash and other liquid assets can help us better understand a business’s financial position. After that, we can increase the company’s liquidity with certain ratio figures, such as the current ratio, quick ratio and cash ratio.
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Liquidity Function
In short, a company’s high liquidity can trigger investor attraction. They will see this as something positive, that our company is financially healthy and has little risk of loss. In the stock market, companies with these characteristics are called blue chip stocks .
Judging from various sources, these are the various functions of company liquidity.
- Become a fund anticipator if at any time the company is faced with sudden needs.
- Measures the availability of cash and cash equivalents to meet short-term debt obligations.
- As a consideration regarding the feasibility of a company in receiving an injection of funds from investors.
- Supporting the running of daily business activities.
- Make it easier for banks to withdraw customer funds.
- Can help company management in monitoring capital efficiency.
- As a tool in analyzing and interpreting the company’s short-term financial position.
- Acting as a trigger for the company to improve the work of its employees.
Types of Liquidity Ratios
A ratio, in accounting terms, is a relationship between two financial variables that are systematically related to each other. Therefore, ratio analysis obtained from the calculation process and the ratio results can be used as material for making decisions regarding a company’s agreement.
The three most important ratios for measuring liquidity are:
1. Current Ratio
The current ratio is a number used to show how much the company is able to fulfill its current obligations using current assets. In addition, this ratio can be used as a comparison between current assets and current liabilities.
The method used to determine the level of the current ratio or current ratio in a company is quite easy, namely by observing the amount of the company’s current assets such as cash, receivables, inventory and other current assets.
If current assets have a greater amount than current liabilities, then the company has a high current ratio. The higher the current ratio, the more certain it is that the company has the ability to pay off its debts or obligations.
This ratio calculates the company’s current assets against its current liabilities. It determines whether the company can pay off all of its short-term debt with the money received from the sale of assets.
The formula used: Current Ratio = Current Assets/Liabilities or Current Debt
2. Quick Ratio
The quick ratio is a ratio that shows how much a company’s ability to pay off its short-term debt without including the value of the company’s inventory. The characteristic of this quick ratio is that it only uses cash and other cash equivalents for its calculations.
It should be noted that the quick ratio is a ratio that shows how much the company is able to pay off its short-term debt using current assets without including the value of the company’s inventory.
This is because inventory takes a relatively long time to be converted into assets, so companies set aside inventory first. Calculation of liquidity levels with the quick ratio only uses tangible assets such as cash and securities as the main component.
If the quick ratio is at the top, then financial conditions should be in a stable condition. This shows that it will be easier for the company to pay off its short-term debt with good financial conditions. Similar to the current ratio, only this quick ratio only considers receivables, cash, and bonds or shares as assets.
Here’s the formula: Current Assets = Current Liquid Assets/Total Liabilities
3. Cash Ratio
This cash ratio is equal to cash divided by current liabilities. Calculating this ratio will be useful when the company can only use its money to pay off debt. If the cash ratio is 1 or greater, it means the business has plenty of liquidity and probably won’t have any problems paying down its debt.
The formula is Cash Ratio = (Cash and Cash Equivalents + Short Term Investments)/Current Liabilities or Debts
4. Cash Turnover Ratio
This cash turnover ratio is used to provide an overview of the amount of profit a company obtains from working capital expenditures. The cash turnover ratio can show a relative figure which is the result of the number of product sales and working capital. The cash turnover ratio calculation can be seen from dividing product sales figures by net working capital.
The result of this cash turnover ratio is the profit the company has achieved from the number of products sold and its working capital. The amount of this return must also be greater than debt to get good liquidity.
Formula: Cash Turnover = Sales/Average Cash and Cash Equivalents
5. Working Capital Ratio
The company must be related to working capital. For this reason, a company will need a working capital ratio to get an idea of their liquidity level. This ratio is seen through the assets and working capital position that can finance the company’s operations.
The working capital ratio calculation is also carried out by comparing the company’s total assets with its liabilities. Then, divide it by the total number of assets
The Importance of Liquidity in Business
At this stage, we certainly already know that liquidity is a very important factor in the sustainability of a business. However, there are still several more things that we need to understand about the importance of liquidity. Let’s see together!
Good liquidity can be a way to match business people with the right short-term investors or borrowers. Companies will be able to present their business with a good impression if they have high liquidity.
Internally, the company also knows their financial status, is it good or bad, risky or not?
The Role of Liquidity in Investment
Apart from business, liquidity is also very important in investing, Mudalovers . We certainly don’t want to give funds to companies we can’t trust, right? Considerations regarding their liquidity need to be made to ensure our investment is not wasted, especially in the long term.
Here are some of the focuses on the role of liquidity in financial planning:
1. As an allowance for cash reserves
We are advised to set aside a small amount of cash for emergencies, regardless of the amount we invest in non-liquid assets. Although the amount of this small reserve varies from person to person depending on their short-term needs, the general advice is to save three months’ income for this.
2. Balancing between Liquid and Illiquid Investments
Ideally, liquid assets such as mutual funds, shares, bonds and other alternatives should be allocated fairly while the rest is allocated to non-liquid assets. As we know, liquid assets can be converted into cash appropriately. This is exactly what we need in saving some wealth.
Even if we don’t invest, we definitely need cash reserves . So, it is necessary to consider having liquid assets that can be saved depending on our monthly budget and various other factors.
Examples of Liquid Assets and Application of Liquidity Ratios
Mudalovers , now we understand about liquidity. However, it certainly feels inadequate if we don’t know real examples in the field. This time, let’s discuss examples of assets that are considered liquid and the application of liquidity ratios in calculating them!
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Examples of liquid and illiquid assets
1. Cash or Cash
Cash is the most liquid asset because it is related to liquidity, all other assets are valued for the ease with which they can be converted into cash, aka cash.
2. Limited Cash ( Restricted Cash )
Restricted cash is a cash deposit as a reserve made by a company for future obligations. This cash amount is also significant. However, these deposits are considered illiquid if they are legally restricted such as compensation for loans.
3. Securities
These are financial instruments that can be traded on public markets. The liquidity of securities is related to the daily trading volume of these securities. Government bonds with high trading volume are considered almost as liquid as cash. Meanwhile, securities with a small value are considered illiquid.
4. Cash Equivalents
Cash equivalents include securities and instruments that can be exchanged for cash such as bills and commercial papers.
5. Credit
Unused credit such as lines of credit can help an entity to achieve liquidity. Even so, such facilities may be subject to conditions that make them much less reliable than cash in a liquidity crisis. For example, if a global financial crisis occurs, banks may have an incentive to revoke credit lines.
6. Assets (Illiquid)
Assets such as inventory, accounts receivable, equipment, vehicles, and real estate are not considered liquid because they take months to convert into cash. If financial stress occurs, these assets may be difficult to convert into cash at all.
Example of Application of Liquidity Ratios
S&S Company has received building materials and other supplies from vendors to complete a project. This vendor certainly hopes that S&S can pay in full after the project is completed. Sometime after S&S was close to completing the project, the company would have to make sure that they had enough money to pay off the loan from the vendor.
Unfortunately, S&S realized that their income was not enough to pay vendors, so they decided to liquidate some of the assets they currently had. Meanwhile, the ratio used to calculate their ability to pay back vendors is the quick ratio.
S&S found that they had USD400 thousand in current liabilities, USD100 thousand in cash, USD100 thousand in marketable securities, and USD300 thousand in receivables. Here’s how to calculate it:
Current Assets = Current Liquid Assets/Total Liabilities
= Cash + marketable securities + receivables/current liabilities
= 100,000 + 100,000 + 300,000/400,000
= 500,000/400,000
With this calculation, S&S can know that their company can still liquidate assets to match and pay off their current debts.
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Conclusion
Mudalovers , liquidity plays a very important role, doesn’t it, in the smooth operation of a company? Not only liquidity, other accounting concepts are of course also needed. Never mind just the business aspect, everyday life and even law will require accounting concepts in several activities!
For those of you who want to know more about the meaning of liquidity and accounting, mudabicara.com has many recommended related articles. Don’t forget, look forward to attractive promotions to get other books. mudabicara.com will always provide the best articles, so that you have the best information.