Essay Preview: Liquidity
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In accounting, liquidity (or accounting liquidity) is the ability measure of a debtor to re-pay his debts. Liquidity ratios helps decision makers in measuring the short-term creditors / suppliers and bankers of the company and also provide valuable and reliable information for financial managers who must meet obligations to suppliers of credit because a complete liquidity ratio analysis can help uncover weaknesses in the financial position of the business. Liquidity can be measured through several ratios.
The most basic liquidity test that shows the ability of a company to meet its short-term liabilities with its short-term assets. Any current ratio that is greater than or equal to one indicates that current assets should be able to satisfy near-term obligations. A current ratio of less than one may mean the firm has liquidity issues. Formula for Current Ratio is Current Assets / Current Liabilities.Current assets refers to net of contingent liabilities on notes receivable while current liabilities refers to all debt that is due within one year.
Current ratio is the generally accepted liquidity ratio where the more liquid the current assets, the smaller the current ratio can be without cause for concern. As the number approaches or falls below 1, you will need to take a close look at the business and make sure there are no liquidity issues. Companies that have ratios around or below 1 should only be those which have inventories that can immediately be converted into cash. If this is not the case and a companys number is low, you should be seriously concerned.
Even if the current ratio is maintained at a ratio of more than 1, you only need not worry on liquidity, there might be a different issues to tackle with. As example, if a company has a current ratio of 3 or 4, you may still want to be concerned because that means the management has so much cash on hand, they may be doing a poor job of investing it or they might have other plan in the near future. Microsoft for example, has a current ratio in excess of 4 which is more that what the company requires for its daily operations and the company has no long term debt on its balance sheet. It turns out they were about to pay its first dividend in history and bought back billions of dollars worth of shares, and made strategic acquisitions.
The Quick Test Ratio (also called the Acid Test or Liquidity Ratio) is the most excessive and difficult test of a companys financial strength and liquidity. Quick Ratio Formula is current assets minus inventory and divide by current liabilities. The quick ratio is a tougher test of liquidity than the current ratio. It eliminates certain current assets such as inventory and advance expenses that may be more difficult to convert to cash. Like the current ratio, the higher the ratio,