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
Current 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 current assets available like cash, inventories, and accounts receivable. 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 assets.
#3 – Cash Ratio
The Cash 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 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 but it does not compare with the industry figures or competitors as these ratios may have different interpretations for different industries.
- There is a number of ratios that measure the accounting liquidity and differ on the basis of 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 assets.
- Accounting liquidity can be assessed by comparing the liquid assets present to the current liabilities or the short term obligations which are due within the period of 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.
- There are different ratios that 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 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 –