What is Liquidity?
Liquidity shows the ease of converting the assets or the securities of the company into the cash i.e., how quickly the assets or the securities can be bought or sold by the company in the market. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses. Before investing a huge sum in any investments, every company needs to look at its liquidity so that it can ensure that even after investing in a project.
Example
Let’s look at the balance sheet first. And then we will talk about Liquidity.
Balance Sheet of MNC Company
| 2016 (In US $) | |
|---|---|
| Assets | |
| Cash | 45,000 |
| Bank | 35,000 |
| Prepaid ExpensesPrepaid ExpensesPrepaid expenses are expenses for which the company paid in advance in an accounting period but which were not used in the same accounting period and have yet to be recorded in the company's books of accounts.read more | 15,000 |
| Inventories | 10,000 |
| Debtor | 20,000 |
| Investments | 100,000 |
| Equipment | 50,000 |
| Plant & Machinery | 45,000 |
| Total Assets | 320,000 |
| Liabilities | |
| Outstanding expenses | 15,000 |
| Creditor | 25,000 |
| Long term debtLong Term DebtLong-term debt is the debt taken by the company that gets due or is payable after one year on the date of the balance sheet. It is recorded on the liabilities side of the company's balance sheet as the non-current liability.read more | 50,000 |
| Total Liabilities | 90,000 |
| Stockholders’ Equity | |
|---|---|
| Shareholders’ equity | 210,000 |
| Retained EarningsRetained EarningsRetained Earnings are defined as the cumulative earnings earned by the company till the date after adjusting for the distribution of the dividend or the other distributions to the investors of the company. It is shown as the part of owner’s equity in the liability side of the balance sheet of the company.read more | 20,000 |
| Total Stockholders’ Equity | 230,000 |
| Total liabilities & Stockholders’ Equity | 320,000 |
From the data given above, find out the Liquidity of the company.
In this example, everything is given. We need to find out which ones are current liabilities and which ones are current assets.
- We call those assets current assets that can be easily converted into cash. In this example, we have cash, bank, prepaid expenses, inventories, and debtorsHave Cash, Bank, Prepaid Expenses, Inventories, And DebtorsA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. read more.
- Current liabilities are those which can be easily paid off. In this example, we have outstanding expenses and creditors.
As we have identified the current assets and the current liabilities, let’s calculate the current ratio first, and then we will calculate an acid test ratioCalculate An Acid Test RatioAcid test ratio is a measure of short term liquidity of the firm and is calculated by dividing the summation of the most liquid assets like cash, cash equivalents, marketable securities or short-term investments, and current accounts receivables by the total current liabilities. The ratio is also known as a Quick Ratio.read more or quick ratio.
Current Ratio
| 2016 (In US $) | |
|---|---|
| Current Assets | |
| Cash | 45,000 |
| Bank | 35,000 |
| Prepaid Expenses | 15,000 |
| Inventories | 10,000 |
| Debtor | 20,000 |
| Total Current Assets | 125,000 |
| 2016 (In US $) | |
|---|---|
| Current Liabilities | |
| Outstanding expenses | 15,000 |
| Creditor | 25,000 |
| Total Current Liabilities | 40,000 |
So, 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 would be as follows –
| 2016 (In US $) | |
|---|---|
| Total Current Assets (A) | 125,000 |
| Total Current Liabilities (B) | 40,000 |
| Current Ratio (A/B) | 3.125 |
- From the current ratio, it’s clear that if MNC Company wants to invest in a new project, it can (of course, there are other factors that need to be looked at) without sacrificing its Liquidity.
- Ideally, a current ratio of 2:1 (meaning 2) is called great for a company. Here, the current ratio is 3.125:1.000 (meaning 3.125). That means the Liquidity of this company is quite good.
Now, we will look at the result of the quick ratio.
Quick Ratio / Acid Test Ratio
The only difference between the quick ratio and current ratio is in quick ratio, we don’t consider “inventories” in current assets.
| 2016 (In US $) | |
|---|---|
| Current Assets | |
| Cash | 45,000 |
| Bank | 35,000 |
| Prepaid Expenses | 15,000 |
| Inventories | Nil |
| Debtor | 20,000 |
| Total Current Assets | 115,000 |
The total current liabilities would remain the same, i.e., $40,000.
So the quick ratio would be as follows –
| 2016 (In US $) | |
|---|---|
| Total Current Assets (A) | 115,000 |
| Total Current Liabilities (B) | 40,000 |
| Current Ratio (A/B) | 2.875 |
From the calculation, it’s clear that even the quick ratio of MNC Company is quite good.
Liquidity – Colgate vs. Procter & Gamble vs. Unilever
Let us now compare the liquidity position of Colgate vs. P&G vs. Unilever. For this, we rely on the two ratios – Current Ratio and Quick Ratio
Current Ratio
Below is the graph depicting the Current Ratios of Colgate, P&G, and Unilever.
- We note that Colgate’s Current ratio has been increasing in the past 3-4 years and is currently at 1.361.
- P&G Current Ratio has declined in the last year and is at 0.877
- Unilever’s Current Ratio has been lowest as compared to Colgate and P&G as is currently at 0.733x
From above, we can deduct that when we compare the three, Colgate has the best liquidity position, whereas Unilever’s current ratio is in a dire situation.
Quick Ratio
The below graph depicts the Quick ratio of the three companies.
We note that the Colgate’s Liquidity is best placed as its Quick ratio is 0.885, whereas Unilever’s Liquidity is in a difficult position with its quick ratio at 0.382.
Conclusion
So, all an investor (a company) has to do before an investment is to ensure that they have enough cash or current assets to pay off the current liabilitiesThey Have Enough Cash Or Current Assets To Pay Off The Current 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.read more. If that doesn’t seem possible, the company can quickly open its balance sheet, calculate the current assets and current liabilities, and calculate the current ratio and quick ratio. If they see that the ratios are more than 1.5-2, then the company is in a good position, at least from the point of view of Liquidity.
One word of caution here – even if Liquidity is good; that doesn’t mean they can invest a lot of money into a project. They need to do an NPVNPVNet Present Value (NPV) estimates the profitability of a project and is the difference between the present value of cash inflows and the present value of cash outflows over the project’s time period. If the difference is positive, the project is profitable; otherwise, it is not.read more or other calculations to know whether the investment is a good idea or not.
Liquidity Video
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This article has been a guide to what is Liquidity and its definition. Here we discuss how to calculate Liquidity using the Current and Quick ratio along with practical examples. You may also learn more about Corporate Finance from the below articles –
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