The priority of any business is solvency and financial stability. The task of an entrepreneur is to avoid a situation when debts ne to be paid. But there is no money for it. That is why it is necessary to calculate and understand the ratio in advance:
- current resources – that is, financial assets;
- liabilities – the money that your business must pay at a certain point in time.
A financial indicator call liquidity is responsible for this. It is relevant for investors, bankers and company managers, since it directly affects strategic planning and the success of the company’s development. Its accounting and control are a priority for any business.
In this article, we will take a closer look at what the term liquidity is. We will analyze how liquidity should be assess, what types of this indicator there are. In particular, we will consider the areas of application of the coefficient, and also give some advice that will help entrepreneurs increase it.
What is liquidity in simple terms
Liquidity is the ability of an organization or individual to quickly convert its assets, such as equipment, materials, raw materials, goods, securities, into money. Typically, for the purpose of paying off debts. Simply put, it is an indicator of how easily a business can pay its own bills from its accumulat resource base.
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The liquidity of a financial asset as a whole is to clearly see how stable the company is and how quickly it can “cover” emerging expenses or pay off part or all of its debts.
For example, a company has stocks of products in a warehouse. It can use them. If it manages to find buyers and quickly sell assets at a good price, then such goods can be call liquid. If the sale takes a long time – weeks, several months, or it is necessary to sell at large discounts, then their average liquidity is low.
Why evaluate a company’s liquidity
The main purpose of assessing and calculating liquidity is to understand whether the company has the funds to repay its own debt on time.
Let’s take two organizations as an example. One always has enough cash in the cash register, products in the warehouse that can be sold quickly, and good quality equipment. Such a company, in case of urgent ne, will be able to find new clients, quickly sell all its assets and be sure to pay off its debts.
Another company owns only a small old warehouse in a remote area of the city. It is impossible to sell it quickly and for good money. The liquidity of this asset is at a minimum level. The business has nothing to sell, there is no cash in the cash register, which means the risk of bankruptcy is high.
In addition, liquidity assessment can be useful for:
1 ) Potential investors and critors. They use this indicator to assess the financial condition of different companies. This way, they can decide whether to invest or provide a loan. Different liquidity is a kind of indicator of the company’s reliability.
2) Understanding how effectively the company’s assets are manag. That is, identifying the degree of liquidity.
Analytics show whether there is a ne to change approaches to managing inventory, debt or finances in general. If the assessment shows that liquidity is insufficient, then it is necessary to optimize business processes and ensure that the risk of bankruptcy in the project is minimal.
Analysis of enterprise liquidity: types, main indicators and calculation formulas
Each production asset can be liquid in its own way. Asset liquidity is divid into several categories depending on how easily each of them can be convert into cash. Usually, specialists consider three types of asset liquidity in a general sense:
- high – the asset can begin to be sold within a few days;
- average – sales take up to several weeks;
- low – implementation from 4 weeks and more.
The faster it is possible to sell an asset, the more priority category it falls into for business. If we consider the balance sheet of an organization and rank the balance sheet items by liquidity, then assets are divid into four categories:
Current liquidity ratio
The liquidity ratio, or “coverage ratio,” demonstrates the extent to which a company is able to cover its short-term liabilities (debts for the next year) using only current assets that can be realiz (A1, A2, A3).
It is us to assess how effectively a company can new website for the colorificio dario garavaglia cope with current debt loads. And it shows whether the owner is ready to pay off the obligations assum in a plann manner. Calculation formula:
The optimal value of current liquidity is between 1.5 and 2. This means that for every unit of short-term liabilities, the company has 1.5-2 units of current assets. That is, it has a good reserve: if necessary, it will be able to pay off all debts, and it will still have resources left.
If the ratio is below 1, there is a risk of bankruptcy. However, when the ratio is too high, it may indicate inefficient use of assets.
Quick ratio
This indicator excludes inventories. Which are consider less liquid assets compar to cash and accounts receivable. The fact is that if a company nes to quickly sell all of its inventory from a warehouse, it will have to significantly ruce the price, which will lead to losses.
Therefore, the quick liquidity ratio helps to assess how well a company can cope with short-term liabilities without taking into account the sale of inventory (A1, A2).
Absolute liquidity ratio
This ratio shows whether the company can pay off its short-term liabilities in a situation where money nes to be paid almost immiately. Therefore, only the most liquid assets of the enterprise are taken into account here—money in accounts and assets that are quickly convert into cash (A1).
The optimal value of the coefficient is about 0.2–0.5. A lower phone number it value may indicate a lack of funds to cover debts in case of unforeseen circumstances. However, a too high coefficient — 0.7 and above — may also indicate inefficient use of funds. The company does not invest funds receiv from critors in production.
What types of liquidity are there: areas of use
Liquidity is an important indicator that plays a key role in various areas of the economy and business. Depending on the area, concept or object to which liquidity is appli, the approaches to its assessment also change. Let us briefly consider the main areas in which the liquidity indicator is us.
