Definition of Liquidity
Liquidity is a company’s ability to convert its assets to cash in order to pay its liabilities when they are due.
Current Assets
Generally, the assets that are expected to turn to cash within one year are reported on the balance sheet in the section with the heading current assets. Current assets are listed in the order in which they are expected to turn to cash. This is known as the order of liquidity. Since cash is the most liquid asset, it is listed first. After cash, the order is: temporary investments, accounts receivable, inventory, supplies, and prepaid expenses.
Evaluating Liquidity
Liquidity depends on 1) the speed at which the assets should be turning to cash, or 2) the assets’ nearness to cash. For example, some temporary investments are marketable and can be converted to cash very quickly. Accounts receivable may be converted to cash in 10 to 40 days. However, inventory may require several months to be sold and the money collected. Hence, inventory is not considered to be a “quick asset.”
To assist in evaluating a company’s liquidity, the financial ratio known as the quick ratio or acid-test ratio is calculated by dividing the amount of the company’s quick assets (cash, temporary investments, and accounts receivable) by the amount of the company’s current liabilities. [An alternate calculation of the quick ratio is to begin with the amount of the current assets and subtract the amount of inventory. The remainder is then divided by the amount of current liabilities.]
Some Inventory May Not Provide Liquidity
While the current ratio is also referred to as a liquidity ratio, a company with the majority of its current assets in inventory may or may not have the liquidity needed to pay its liabilities as they come due. Its liquidity depends on the speed in which the inventory can be converted to cash.
