Liquidity – What is liquidity?
Liquidity, or accounting liquidity, measures the ability of an individual or company to meet their short-term financial obligations.
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A debtor is considered to have a high level of liquidity if they can purchase new assets with ease and pay short-term debts when they are due. Liquidity is usually presented as a ratio or a percentage of current liabilities.
Cash as a measure of liquidity
A high level of liquidity is typically indicated by large sums of cash or significant amounts of current assets. Cash is considered as the standard measure of liquidity, as cash can be used to pay off debts or make purchases more quickly and easily than other types of assets.
For example, if a business wants to buy a new computer for £500, they can purchase the computer most quickly if they have enough cash. If the business has a piece of machinery valued at £500, they would either need to trade the two assets – which is extremely unlikely – or sell the machinery then use the cash from the sale to purchase the computer.
How to calculate liquidity
There are several different formulas and ratios to calculate and measure a company’s liquidity. Some of the most common ratios are the current ratio, the quick ratio, and the cash ratio.
Calculating liquidity with the current ratio
The current ratio is the easiest way of measuring liquidity, whereby you divide total current assets by total current liabilities. According to the current ratio, the higher the ratio, the higher the liquidity. If a company has a ratio above 1, they are considered to be able to pay their short-term obligations. To calculate a company’s current ratio, use the following formula:
Current ratio = current assets ÷ current liabilities
Calculating liquidity with the quick ratio
Also known as the acid test, the quick ratio is more conservative than the current ratio as it does not consider current assets such as inventory. The following formula calculates a company’s quick ratio:
Quick ratio = (cash equivalents + marketable securities + accounts receivables) ÷ current liabilities
Calculating liquidity with the cash ratio
The cash ratio does not consider accounts receivables or inventory; it therefore measures a company’s liquidity as if it were about to go out of business. Whilst this is useful for telling creditors the value of highly liquid assets, this ratio is not commonly used in financial reporting. The cash ratio is as follows:
Cash ratio = (cash + marketable securities) ÷ current liabilities
Alternative definitions of liquidity
Liquidity is most commonly used to refer to accounting liquidity, which should not be confused with asset liquidity or market liquidity.
Asset liquidity applies to individual assets rather than a company as a whole, and describes the extent to which an asset can be converted into cash at short notice, without reducing the asset’s price.
Market liquidity describes how easily assets can be bought and sold at stable prices within specific markets (e.g. a nation’s stock market, a local real estate market) .