Have Mudalovers ever wondered what liquidity is and how to calculate it using ratios? Read the following explanation so that Mudalovers can find out how long the company can finance business operations and other benefits that Mudalovers will get.
Understanding Liquidity
Before discussing liquidity further, Mudalovers needs to first understand the meaning of liquidity. Liquidity is the ability or power of a company to pay debt and short-term obligations. Examples of short-term debt are taxes, business debt, dividends, and so on.
However, there are also those who say that the definition of liquidity is the ability of individuals or companies to pay off debts or obligations with current assets. If the company does not have the power to pay off its obligations, it will be impossible for the company to be able to carry out operational activities as before.
In general, each company has a different level of liquidity which is shown in certain figures, such as the quick ratio figure, current ratio figure and cash ratio figure. The higher it is, the better Mudalovers opinion is that the company has better performance in carrying out its operational activities. With its high level, it can attract investors, for example financial institutions, creditors and suppliers.
The Role of Liquidity
To run a business, there are several obligations that Mudalovers needs to fulfill. This obligation is the obligation to pay debts and also the obligation to finance all the company’s operational needs. These two obligations are known as liquidity.
If a company is able to pay these obligations then it can be said that the company’s liquidity is good, but if the company is unable to pay all these costs then the company can be categorized as a bad company.
That is where the important role of liquidity is, by knowing the paying ability of a company, the benchmark for the success of SMEs can be assessed.
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Benefits and Functions of Liquidity
Mudalovers needs to know that liquidity in a company has its own functions and benefits for the company’s operational processes. Some of the functions and benefits of liquidity include:
- As the right media for carrying out the company’s daily business activities.
- As a tool to anticipate if there is a sudden or urgent need for funds.
- For companies operating in the financial sector, it can make it easier for customers to make loans or withdraw funds. Companies can use the help of financial management software to obtain maximum optimization in business management.
- As a reference for a company’s level of flexibility in obtaining approval for investments or other profitable businesses.
- Tools that can trigger companies to make efforts to improve performance.
- As a benchmark for the level of a company’s ability to pay short-term obligations.
- Can help management to check working capital efficiency.
- Assist companies in conducting analysis and interpreting short-term financial positions.
Therefore, maintaining the level of liquidity is important because it can gain trust from internal and external parties. With a good level of liquidity, companies can pay employee salaries according to predetermined dates and easily obtain capital loans from investors, banks and other parties.
Components Contained in Liquidity
Next, what Mudalovers needs to know is understanding the components of liquidity. The main components of liquidity can be divided into three parts. The following are the three components:
- Density is a gap or distance that can explain the price distance for a product, including the normal price distance and the price distance that the company has agreed to.
- Depth is a component that explains the volume of sales and purchases of a product at a certain price level.
- Resilience is an explanation of the speed of price changes towards efficient prices after instability or price deviations occur.
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Examples of Liquid Assets and Application of Liquidity Ratios
Mudalovers, after we understand liquidity. However, it certainly feels lacking if we don’t know real examples of liquidity in everyday life. This time, let’s discuss examples of assets that are considered liquid and the application of liquidity ratios in calculating them!
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 assessed based on the ease with which they can be converted into cash or cash.
2. Limited Cash (Restricted Cash)
Restricted cash is a cash deposit as a reserve made by the company to meet future obligations. This cash amount is quite significant. However, these deposits are considered illiquid if they are legally limited, such as compensation for loans.
3. Securities
Securities are financial instruments that can be traded on the public market. The liquidity of securities is related to the daily trading volume of these securities. Government bonds that have high trading volume are considered to be almost as liquid as cash. Meanwhile, securities that have a small value are considered illiquid.
4. Cash Equivalents
Cash equivalents are securities and instruments that can be exchanged for cash, such as commercial papers and bills.
5. Credit
Unused credit such as lines of credit can help an entity to achieve liquidity. However, such facilities may be subject to conditions that make credit much less reliable than cash in a liquidity crisis.
For example, in the event of a global financial crisis, banks may have an incentive to withdraw credit lines.
6. Assets (Illiquid)
Assets including inventory, receivables, equipment, vehicles, and real estate are not considered liquid because they take a long time such as months or even years to be converted into cash. If financial stress occurs, these assets may be more difficult to convert into cash.
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Calculating Liquidity Using Ratios
After knowing what liquidity means and its functions and benefits, Mudalovers certainly wants to know how to calculate it. To calculate this, Mudalovers can use the liquidity ratio formula, so as to find out whether the company’s liquidity is in good condition or not. This calculation can be divided into four types of liquidity ratios, namely:
1. Current ratio
This calculation is used to find out to what extent the company’s current assets can cover its short-term debt. If the results show a high enough value, the higher the company’s ability to cover its short-term debt. The following is the formula for calculating it using the current ratio:
CURRENT RATIO = CURRENT ASSETS : CURRENT LIABILITIES
If the current ratio is low, such as below 1.2, then this indicates that the company does not have the ability to pay its short-term debt. However, a lower value can also indicate that the company has used its current assets effectively and efficiently.
2. Quick ratio (Quick ratio)
The quick ratio is used to calculate inventory of goods which is part of current assets which is useful for paying off short-term liabilities. This happens because disbursement of inventory takes longer. To calculate the quick ratio, try using the formula below:
QUICK RATIO = (CURRENT ASSETS – INVENTORY) : CURRENT PAYABLES
If the result is more than 1.0, then the company’s ability to pay off short-term debt is considered very good. However, if the value is above 3.0, then the company’s ability will be considered less productive.
This is because current assets are not utilized optimally in other forms of investment or the profit target is not appropriate. Through the quick ratio, Mudalovers can see whether the company’s cash flow is running healthily or unhealthy.
3. Cash Ratio (Cash ratio)
The cash ratio is a way to measure the amount of cash available and used to pay off the company’s short-term debt. It is recommended that this ratio figure be comparable between cash and debt, namely 1:1.
If the ratio of cash is greater than cash compared to short-term debt, then the value of the cash ratio is good, because there is the availability of funds that can be used to pay off short-term obligations. Here’s how to calculate the cash ratio using the formula:
CASH RATIO = CASH AND CASH EQUIVALENTS: SHORT TERM DEBT
The meaning of cash and cash equivalents here can include company cash or securities that are easy to liquidate, such as bonds or engineered funds when the Mudalovers company needs emergency funds.
4. Cash turnover ratio (Cash turnover ratio)
With this ratio, Mudalovers can see how many times the company’s cash turns over in one period which is assessed through sales. To calculate it, you can use the following formula:
CASH TURNOVER = NET SALES : AVERAGE CASH
If you find a larger ratio value, the value of the company’s ability to overcome financial problems will also be greater.
Apart from that, circulating cash shows that the faster cash enters the company, meaning that income will also increase so that cash for operational activities can also run smoothly.