Key Takeaways
- Liquidity refers to how easily an asset can be converted into cash
- Most common ratios used to calculate liquidity are the current ratio, quick ratio and operating cash flow ratio
- it is important to understand an assets liquidity level before investing in it because it could take time to convert back to cash.
What is Liquidity?
In financial terms, liquidity refers to how easily an asset can be converted into cash. Assets like property, equipment and plants are very difficult to convert into cash, hence they are not very liquid. However, assets like stocks and bonds can be converted into cash within days, hence they are very liquid.
In financial markets, liquidity implies how quickly an investment can be sold without adversely affecting its price. The more liquid the investment is, more quickly can it be sold. In financial analysis, liquidity measures how quickly and effectively a business can meet its short term financial obligations such as paying off their liabilities. The cash that the company generates, by liquidating its assets and fulfilling its financial obligation is used by the company to either expand the business or pay its shareholders via dividends, is also referred to as cash flows.
Understanding Liquidity
The most common ratios used to calculate and measure a company’s liquidity are as follows:
- Current Ratio
This is also known as the working capital ratio. The current ratio is calculated by dividing the company’s current assets by the current liabilities. ‘Current’ itself refers to short term assets and liabilities that can be used and paid off in a time span of less than a year. A company should ideally have a current ratio greater than 1, which would imply that the company has more current assets than their liabilities. For competitive analytical purposes, comparison of ratios should take place between companies operating within the same industry for accurate representation.
- Quick Ratio
This is also known as the acid test ratio. The quick ratio is almost the same as the current ratio, except that it does not include inventory in its calculations. This is because inventory is not as liquid and is converted to cash with difficulty. Like the current ratio, a value greater than 1 implies good liquidity. However, this is still subjected to the industry’s average and should only be analysed in comparison to it.
- Operating Cashflow Ratio
This ratio measures how effectively the cash flow generated from the business operations cover the company’s current liabilities. The operating cash flow ratio is calculated by dividing operating cash flow by the company’s current liabilities. Higher the number, better is the company’s ability to cover current liabilities. This is an indication of the company’s financial health.
Components used in the calculations of the above-mentioned ratios are found in a company’s balance sheet where items are usually listed from the most liquid (cash) to least liquid (property, plant and equipment).
From an investor’s perspective, it is important to understand an asset’s liquidity level before investing in it because it could take time to convert back to cash.
