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 its liquidity so that it can ensure that even after investing in a project.
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 calculate these two ratios – current ratio, quick ratio/acid test ratio.
What would do here is to make a balance sheet and calculate two ratios using the data. It will help us understand liquidity quite well.
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 that 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 calculate 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 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 liabilities. 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 NPV or other calculations to know whether the investment is a good idea or not.
Liquidity Video
Recommended Articles
This 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 –
