Liquidity

What is Liquidity?

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 their liquidity so that they can ensure that even after investing into a project; they will have enough cash and liquidity to pay off the current assets.

There are two ratios which that can ensure whether the company has enough cash or not – Current Ratio and Quick Ratio

All the company has to do is to look at their balance sheet at the time of investments and see the current assets and current liabilities and then compute these two ratios – current ratio, quick ratio/acid test ratio.

What would do here is to take a balance sheet and compute two ratios using the data. It will help us understand liquidity quite well.

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Liquidity 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 Expenses	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 debt	50,000
Total Liabilities	90,000

Stockholders’ Equity
Shareholders’ equity	210,000
Retained Earnings	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 which can be easily converted into cash. In this example, we have cash, bank, prepaid expenses, inventories, and debtors.
• 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 compute the current ratio first and then we will calculate an acid test ratio 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 ratio 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 into 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 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 Current Ratios of Colgate, P&G and Unilver.

• 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, Unilevers current ratio is in a dire situation.

Quick Ratio

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 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 liabilities. If that doesn’t seem possible, the company can quickly open their balance sheet, compute 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 NPV or other calculation to know whether the investment is a good idea or not.

Liquidity Video

Recommended Articles

This has been a guide to What is Liquidity along with practical examples. Here we calculate liquidity of a company using the Current Ratio and Quick Ratio. You may also learn more about Corporate Finance from the below articles –

• Prepaid Expense Examples
• Quick Ratio Formula
• Current Ratio Formula
• Cash Ratio Formula
• Working Capital Formula