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What is liquidity?

Liquidity refers to a company's ability to convert its assets to cash in order to pay its liabilities when they are due.

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. There they 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 will appear first. After cash, the order is: temporary investments, accounts receivable, inventory, supplies, and prepaid expenses.

You can think of the order of liquidity as 1) the speed in which the assets should be turning to cash, or 2) the assets' nearness to cash. For example, a temporary investment is one that can be quickly converted to cash. Accounts receivable will be converted to cash rather quickly, perhaps within 30 days. However, inventory could require several months to be sold and the money collected. Hence, inventory is not considered to be a "quick asset." Supplies and prepaid expenses may take many months before they are used up.

To assist in evaluating a company's liquidity, the financial ratio known as the quick ratio or acid-test ratio divides 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.]

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.