Accounting Liquidity

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:

Accounting-Liquidity

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For eg:
Source: Accounting Liquidity (wallstreetmojo.com)

#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 read more 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.read more. The higher is the current ratio, the better is the liquidity position of the companyLiquidity Position Of The CompanyLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read more.

Formula to calculate the current ratio:

Current Ratio = Current Assets/Current Liabilities

#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.read more.

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.read more:

Quick Ratio = (Cash and Cash Equivalent + Accounts Receivable + Short term Investments)/Current Liabilities

Or

Quick Ratio = (Current Assets – Inventories – Prepaid Costs)/Current Liabilities

#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.read more 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:

Cash Ratio = (Cash and Cash Equivalent+Short term Investments)/Current Liabilities

Example of Accounting Liquidity

There are two companies, X ltd and the Y ltd working in the same industry have the following details.

You can download this Accounting Liquidity Excel Template here – Accounting Liquidity Excel Template

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.

Analysis

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:

Accounting Liability Example 1
Accounting Liability Example 1-1

Similarly, for Y Ltd,

For Y ltd:

Example 2
Example 2-1

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:

  1. 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.
  2. It is easy to measure and calculate accounting liquidity.
  3. It is helpful for the management of the company in assessing the performance of the company.
  4. 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.

Disadvantages

Limitations and drawbacks of the accounting liquidity include the following:

  1. 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.
  2. 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.
  3. 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.

Important Points

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