What is Liquidity in Accounting?
Accounting liquidity measures the ability of the debtor of the company with respect to their debt payments and the same is usually expressed in terms of percentage of the current liabilities, for example, current ratio can be measured as current assets divided by current liabilities which are helpful for company in knowing the liquidity of company so that company does not face any liquidity crunch in near future.
Accounting Liquidity Formula
There are various ratios which measure the accounting liquidity of a person which are as follows:
#1 – Current Ratio
The Current RatioCurrent RatioThe current ratio is a liquidity ratio that measures how efficiently a company can repay it' short-term loans within a year. Current ratio = current assets/current liabilities measures the ability of the company to pay the current liabilities which are payable within the period of next one year with respect to its current assets available like cash, inventories, and accounts receivableAccounts ReceivableAccounts receivables refer to the amount due on the customers for the credit sales of the products or services made by the company to them. It appears as a current asset in the corporate balance sheet.. The higher is the current ratio, the better is the liquidity position of the company.
Formula to calculate the current ratio:
#2 – Acid-Test/Quick Ratio
The quick ratio measures the ability of the company to pay the current liabilities which are payable within the period of next one year with respect to its most liquid assets. In order to calculate the most liquid assets, inventories and prepaid costs are excluded from the current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc..
Calculate Quick RatioCalculate Quick RatioQuick Ratio is calculated by dividing cash and cash equivalents, marketable securities and accounts receivables by Current Liabilities. Quick Ratio Formula is one of the most important Liquidity Ratios for determining the company’s ability to pay off its current liabilities in the short term.:
#3 – Cash Ratio
The Cash ratioCash RatioCash Ratio is calculated by dividing the total cash and the cash equivalents of the company by total current liabilities. It indicates how quickly a business can pay off its short term liabilities using the non-current assets. measures the ability of the company to pay the current liabilities which are payable within the period of next one year with respect to its cash or cash equivalents. The cash ratio defines the liquid assets strictly the cash or cash equivalents. It assesses the ability of the company to stay solvent if there comes any emergency as even a highly profitable company sometimes can go into trouble in case if they no liquidity is there to meet unforeseen events. Its formula to calculate the Cash ratio:
Example of Accounting Liquidity
There are two companies, X ltd and the Y ltd working in the same industry have the following details.
For X ltd:
- Current Assets: $ 35
- Current Liabilities: $ 10
- Inventories: $ 10
For Y ltd:
- Current Assets: $ 12
- Current Liabilities: $ 20
- Inventories: $ 6
Comment on the accounting liquidity of the two companies.
In order to analyze the accounting liquidity position of the Companies X ltd and Y ltd liquidity ratios will be calculated from the available information where,
- Current Ratio = Current Assets/Current Liabilities and
- Quick Ratio = (Current Assets – Inventories)/Current Liabilities
For X ltd:
Similarly, for Y Ltd,
For Y ltd:
The current ratio of X ltd is more than that of the Y ltd, which shows that the X ltd has a high degree of liquidity. The quick ratio of X ltd. also points to the adequate level of liquidity as even after excluding the inventories of $2 from current assets, it has $2.5 cash for every dollar of the current liabilities.
Advantages of the Accounting Liquidity
There are several different advantages of the Accounting Liquidity for the company or an individual. Some of the advantages are as follows:
- It helps in determining whether the company has sufficient liquidity to meet its short term obligations or not so that the company can plan its future course of action accordingly.
- It is easy to measure and calculate accounting liquidity.
- It is helpful for the management of the company in assessing the performance of the company.
- It is used by the banks, investors, creditors, and other stakeholders as part of their analysis before providing credit or investing their money in the company.
Limitations and drawbacks of the accounting liquidity include the following:
- The accounting liquidity is calculated based on the figures, and there are chances that these figures are manipulated by the company. In that case, accounting liquidity calculated will not show the correct picture of the liquidity position of the company.
- The accounting liquidity helps in knowing that whether sufficient liquidity to meet short term obligations is there or not with the particular company. Still, it does not compare with the industry figures or competitors as these ratios may have different interpretations for different industries.
- There are several ratios that measure the accounting liquidity and differ based on how strictly a liquid asset is defined in them. Each ratio defines liquid assets differently, so there is no concrete conclusion that which ratio is best to measure accounting liquidity.
- Accounting liquidity is a measure of easiness with which a company or an individual can meet with their financial obligations using the liquid assets which are available with them.
- Accounting liquidity measures the ability to pay off outstanding debts as and when they become due using its liquid assetsLiquid AssetsLiquid Assets are the business assets that can be converted into cash within a short period, such as cash, marketable securities, and money market instruments. They are recorded on the asset side of the company's balance sheet..
- Accounting liquidity can be assessed by comparing the liquid assets present to the current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc. or the short term obligations, which are due within one year.
- Accounting liquidity is one of the important measures used to know the ability of a person to pay off its current debt obligations due within the next year without a need to raise external capital.
- Different ratios measure the accounting liquidity that includes the current ratio, quick ratio, and cash ratio. If the person has more liquid assets when compared with its current liabilities or short term obligations than it shows that the accounting liquidity of the person is sufficient otherwise is not, than it will be able to meet its obligations on time.
This article has been a guide to what is Liquidity in Accounting? Here we discuss the formula to calculate the top 3 accounting liquidity ratios along with examples, advantages, and disadvantages. You can learn more about accounting from the following articles –