The financial liquidity ratios indicate the ability of a company to meet obligations that are close to maturity in the short term. If a company is borrowing for a short period of time or there are some large bills to pay soon, the analyst will want to make sure they can get their hands on the cash when they need it. The banks and providers of the company also need to keep an eye on the liquidity of the company, they know that companies without liquidity are more likely to fail and stop meeting their debts.
What is liquidity?
Sepúlveda (p.120) defines liquidity as the ease with which an asset can be transformed into money. Liquidity depends on two factors: the time required to convert the asset into money and the certainty of not incurring losses when making the transformation, therefore, money is the most liquid of all assets.
According to Durán (p.164), liquidity is understood as the ease with which an asset can be transformed into money without suffering a significant loss in value. It is generally determined by the nature of the market in which it is traded. Thus, the most liquid of the assets is, logically, the currency or paper money. The shares of a company can be more or less liquid depending on the average volume of business and the free float of the company (proportion of the capital of the company that is freely quoted in the market), although it is generally understood that they are fairly liquids since they are listed on an organized market (the Stock Exchanges), where they can be bought and sold with relative ease. On the contrary, a property would be a clear example of illiquid value,since its sale requires a considerable time and some obligatory legal formalities. The term can also be applied to an institution or an individual. Thus, it is understood that a company is liquid if a large part of its assets is in the form of cash or if it can be quickly converted into cash. This conception of liquidity provides an indication of the company's ability to meet its short-term commitments. If the lack of liquidity becomes permanent, the situation may degenerate into the technical bankruptcy of the company.A company is understood to be liquid if a large part of its assets is in the form of cash or if it can be quickly converted into cash. This conception of liquidity provides an indication of the company's ability to meet its short-term commitments. If the lack of liquidity becomes permanent, the situation may degenerate into the technical bankruptcy of the company.A company is understood to be liquid if a large part of its assets is in the form of cash or if it can be quickly converted into cash. This conception of liquidity provides an indication of the company's ability to meet its short-term commitments. If the lack of liquidity becomes permanent, the situation may degenerate into the technical bankruptcy of the company.
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Liquidity ratios
Because a common precursor to financial problems and bankruptcy is low or declining liquidity, these reasons give early signs of cash flow problems and impending business failures. Of course, it is desirable for a company to be able to pay its bills, so having enough liquidity for day-to-day operations is very important. However, liquid assets, such as cash held in banks and marketable securities, do not have a particularly high rate of return, so shareholders will not want the company to overinvest in liquidity. Companies need to balance the need for security that liquidity provides against the low returns that liquid assets generate for investors.
The following basic liquidity measures are commonly used in financial analysis:
Current ratio or current liquidity
Liquidity measure that measures the ability of the company to meet its short-term obligations, is calculated by dividing the current assets (current) of the company by its current liabilities (current), the minimum that is generally considered to be acceptable is 2 to 1, although it may vary depending on the industry or economic sector of the firm.
Current assets include the money a company has in the box and in the bank, plus any assets that can be converted into cash within the "normal" twelve-month period of operations, such as marketable securities that are held as short-term investments. term, accounts receivable, inventories and advance payments. Current liabilities include any financial obligations maturing in the following year, such as accounts payable, obligations payable, the long-term debt due, other accounts payable, and accrued taxes and wages payable.
In general, the higher the current liquidity, the greater liquidity the company has. The amount of liquidity a company needs depends on several factors, including the size of the organization, its access to short-term sources of financing, such as bank lines of credit, and the volatility of its business. For example, a grocery store whose income is relatively predictable may not need as much liquidity as a manufacturing company that faces sudden and unexpected changes in demand for its products. The more predictable a company's cash flows are, the lower the acceptable current liquidity.
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Acid test or quick ratio
Liquidity measure that is calculated by dividing the current assets (current) of the company minus inventory, by its current liabilities (current).
This financial ratio is a stricter measure of liquidity. By eliminating inventories of current assets, financial reason recognizes that these are often one of the least liquid current assets. Inventories, especially work in process, are very difficult to quickly convert to or near book value. Low inventory liquidity is generally due to two primary factors: 1. Many types of inventory cannot be easily sold because they are partially finished products, special-purpose items, or the like; and 2. inventory is generally sold on credit, which means it becomes an account receivable before it becomes cash.An additional problem with inventory as a liquid asset is that when companies face the most pressing need for liquidity, that is, when business is bad, it is precisely the time when it is most difficult to convert inventory into cash through sale. The fundamental assumption of acid proof is that a company's accounts receivable may be converted into cash within the "normal" recovery period (and with little "reduction") or within the term in which the credit was originally granted.is that a company's accounts receivable may be converted into cash within the "normal" recovery period (and with little "reduction") or within the term in which the credit was originally granted.is that a company's accounts receivable may be converted into cash within the "normal" recovery period (and with little "reduction") or within the term in which the credit was originally granted.
As in the case of current liquidity, the level of the quick ratio a company must strive to achieve depends largely on the industry in which it operates. The quick ratio offers a better measure of comprehensive liquidity only when the company's inventory cannot easily be converted into cash. If the inventory is liquid, current liquidity is a preferable measure for overall liquidity.
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Cash ratio
A company's most liquid assets are its holdings of cash and easy-to-sell securities. This is the reason why analysts also look at the cash ratio, which is calculated as cash plus short-term values divided by current liabilities.
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To end, the following video-lesson is suggested, given by Professor Einar Moreno of the University of the Americas, Puebla, through which you can continue learning about liquidity ratios or indicators in companies.
Bibliography
- Brealey, Richard A., Myers, Stewart C. and Allen, Franklin. Principles of corporate finance. McGraw-Hill Interamericana editors. 2010.Durán Herrera, Juan José. Finance Dictionary. Ecobook, Economist Editorial, 2011.Gitman, Lawrence J. and Zutter, Chad J. Principles of Financial Management. Pearson Education, 2012.Moyer, Charles R., McGuigan, James R. and Kretlow, William J. Contemporary Financial Management. International Thomson Editores. 1999.Sepúlveda L., César (Editor). Dictionary of economic terms. University Publishing House, 2004.
