Question

The company is in a liquidity crisis. To define and identify a liquidity crisis, select two accounting subjects in the financial statements you want to look at and explain why.

Answer 1

Liquidity is simple terms refers to the ability to convert assets into cash.

A liquidity crisis is a situation where organisation faces a lack of cash or easily-convertible-to-cash assets on hand across many businesses or financial institutions simultaneously.

Generally liquidity issues can be identified by the following process

1.The Current Ratio :-

Financial ratios are comparisons of financial data like earnings, assets and debt. The current account ratio is a common financial ratio that can indicate liquidity problems. The current account ratio is equal to a company's current assets divided by its current liabilities. Current assets include cash and other assets like short- and long-term investments and inventories. The higher the current account ratio, the more likely a company is to have adequate liquidity to meet its short-term obligations.

Current Ratio = Current Assets/ Current Liability

2. Cash Account Ratio:-

The cash account ratio is similar to the current account ratio, but it only includes cash and assets that are easily convertible to cash, like stock investments. The cash account ratio is equal to cash plus marketable securities divided by current liabilities. If cash ratio is close to one, it means the company barely has enough liquidity to fulfill its obligations.

3. Profitability:-

Every business needs to make profit in the long term to be successful. Small businesses often start out losing money as they build up a base of customers and build brand awareness. When a company is not profitable, it loses money over time, which diminishes cash reserves and liquidity. If a company is not profitable after its initial start-up phase, it indicates that the company may face liquidity problems in the future.