Liquidity definitions and examples
Liquidity is a company's ability to pay its obligations when they are due. Expressed another way, liquidity is the company's ability to convert its current assets to cash before its current liabilities must be paid.
The first section of most balance sheets will report a company's current assets in their order of liquidity. This means that cash will appear first, followed by the remaining current assets in the order in which they are expected to be converted into cash. (The current liabilities which must be paid are not listed in the order in which they are due.)
Importance of liquidity
To demonstrate the importance of liquidity, we will use a fictitious business called "Example Company". Let's assume that Example Company's suppliers have given it credit terms that allow 30 days in which to pay. If Example Company does not have the liquidity to pay the suppliers' invoices in 30 days, the suppliers may be concerned about Example Company's financial condition. In response, a supplier might require Example Company to become current on all unpaid invoices before the supplier will ship any additional goods. A different supplier may shorten the credit terms for Example Company from 30 days to 10 days or may require cash on delivery. If Example Company loses its ability to pay on credit terms, its cash and liquidity will shrink.
Failure to pay obligations on time may also harm a company's credit rating. This in turn may discourage other suppliers (and lenders) from extending credit to the company.
If a company has borrowed money, the loan agreement may require that the company maintain a minimum amount of working capital and/or maintain certain financial ratios. Being in violation of a loan agreement can have serious ramifications.
On a positive note, a company with ample liquidity can take advantage of special purchasing opportunities, take early payment discounts when offered, and save time by not having to decide which vendors and bills should be paid or delayed.
The importance of a company's liquidity is evident by the financial reporting requirements for publicly-held corporations. Each of these corporations must include in its annual report to the U.S. Securities and Exchange Commission (Form 10-K) a discussion of its liquidity. Typically this discussion will reference amounts contained in the corporation's statement of cash flows. Business people of all backgrounds should become familiar with the statement of cash flows since a company's liquidity depends on its cash flows.
Both a company's liquidity and the amount of its working capital can be increased through:
- Profitable business operations
- Sale of long-term assets
- Long-term loans
- Additional investments by owners
It is also possible to improve a company's liquidity without increasing the amount of working capital by the following actions:
- Increasing the speed in which current assets are converted to cash
- Speeding up the collection of accounts receivable
- Purchasing or producing more optimum quantities for inventory
- Requiring smaller customers and new customers to use a credit card instead of the company granting credit terms
- Delaying the payment of current liabilities
- Not remitting money to vendors until the due date
- Arranging with vendors for longer credit periods
- Using a business credit card whenever possible
- Delaying the payment of long-term liabilities
- Reducing or omitting the distribution of cash to owners
- Obtaining a pre-approved line of credit that can be used when necessary
- Arranging for monthly installments instead of prepaying insurance premiums, maintenance contracts, memberships, etc.
Working Capital Ratios
In addition to calculating the amount of working capital, it is common to compute two related financial ratios:
- Current ratio
- Quick ratio
The current ratio, which is sometimes referred to as the working capital ratio, is calculated by dividing a company's current assets by its current liabilities. The current ratio computed by using the amounts on our earlier condensed balance sheet is:
Current ratio = current assets of $170,000 divided by the current liabilities of $100,000 = 1.7, or 1.7:1, or 1.7 to 1
The current ratio allows for a comparison between companies of different sizes. However, knowing a company's current ratio and its amount of working capital is still not enough. It is also important to know when the individual current assets will be turning to cash and when the current liabilities will need to be paid.
To illustrate the importance of knowing when the current assets will turn to cash and when the current liabilities are due for payment, let's compare two companies of similar size and growth potential:
Company A sells fast-selling products online and requires customers to pay with a credit card when ordering. Hence, within a few days after an online sale takes place, Company A receives a bank deposit from the credit card processor. Company A is also allowed to pay its main supplier 30 days after receiving the supplier's goods and invoice.
Company B sells slow-moving products to business customers who pay 30 days after receiving the products. Unfortunately, Company B must pay its suppliers within 10 days of receiving the products it had ordered.
Since Company A's cash will flow in faster and will flow out slower than Company B's, Company A can operate with a smaller current ratio and a smaller amount of working capital than Company B.
When a company sells goods (products, component parts, etc.) there is a concern that its items in inventory will not be converted to cash in time for the company to pay its current liabilities. Hence, the company could have difficulty making its loan payments, paying its suppliers and employees, remitting employees' payroll withholdings, etc. In short, when a company has inventory, there is a concern about the company's liquidity.
This concern has led to the quick ratio (or acid test ratio) which excludes inventory, supplies and prepaid expenses. Therefore, the quick ratio is more conservative than the current ratio and will be calculated by using the following amounts:
- Only the "liquid" current assets (the ones that can be quickly converted to cash)
- The total amount of current liabilities
From our earlier list of current assets the "quick assets" as of the balance sheet date were:
This $65,000 of quick assets will be divided by the total amount of current liabilities, which were $100,000:
Quick ratio = $65,000 of quick assets divided by $100,000 of current liabilities = 0.65, or 0.65:1, or 0.65 to 1
(Note: Since inventory was a significant current asset, the quick ratio is significantly smaller than our earlier calculation of the current ratio which was 1.7, or 1.7:1, or 1.7 to 1.)
Some people calculate the quick ratio by merely subtracting the inventory amount from the total amount of current assets:
By not subtracting supplies and prepaid expenses from the total current assets, this quick ratio will be slightly less conservative than the quick ratio of 0.65 computed above:
Quick ratio = $71,000 divided by the $100,000 of current liabilities = 0.71, or 0.71:1, or 0.71 to 1