Liquidity
Liquidity refers to the ability with which an asset can be changed into cash. This measures the short-term solvency of the business, or its ability to meet its short-term financial debts. An analysis of a firm’s current position normally includes determining the:
- Cash in Bank
- Working capital
- Current ratio
- Quick ratio
Current Assets
Current Assets are those assets which can be converted into cash within a maximum period of one year (or) during the normal operating cycle of the business.
Current Assets include:
- Cash Balance
- Cash at Bank
- Accounts receivable
- Stock
Current Liabilities
Current Liabilities are the debts which are to be paid within a year or during the normal operating cycle of the business.
Current Liabilities includes:
- Creditors
- Accounts Payable
- Outstanding Expenses
Working Capital
Working capital is the difference between Current Assets and Current Liabilities.
Working Capital = Current Assets - Current Liabilities.
Example
Current Assets = $1,000
Current Liabilities= $700
Working Capital = Current Assets - Current Liabilities
Working Capital = $1,000 - $700
= $300
Current Ratio
Current ratio is the relationship between Current Assets and Current Liabilities.
| Current Ratio | = | Current assets |
Current Liabilities |
Example
| Current Assets | $2,000 |
|
| Current Liabilities | $500 |
|
| Current Ratio | = 2,000 | = 4:1 |
|
|
500
|
The ratio of 2:1 is considered to be an ideal ratio. It indicates that the business is able to pay its current debts and has two times the current assets over current liabilities. A low ratio indicates that a company may find it difficult to pay its current debt.
Quick Ratio
Quick ratio is the relationship between total quick assets to the total Current Liabilities.
Quick Assets contain the following details:
- Cash
- Marketable Securities
- Accounts Receivable
The Quick Ratio is calculated by dividing the total cash and receivables by total current liabilities.
| Quick Ratio | = Quick Assets |
|
| Current Liabilities |
Example:
|
| Cash | = $2,000 |
|
| Accounts Receivable | = 6,000 |
|
| Current Liabilities | = 3,000 |
| Quick Ratio | = 8,000 | = 2.66 : 1 |
|
| 3,000 |
|
The ideal quick ratio is 1: 1. It indicates that for every single current liability, the business has one quick asset. The higher the ratio, the greater the ability to pay current debts.