Question

Why are we concerned about liquidity and what are the most common measures of a company's liquidity?

Answer 1

Solution:

Liquidity and Concerns

Liquidity is the term used to describe how easy it is to convert assets to cash. The most liquid asset, and what everything else is compared to, is cash. Certificates of deposit are slightly less liquid, because there is usually a penalty for converting them to cash before their maturity date. Savings bonds are also quite liquid, since they can be sold at a bank fairly easily. Finally, shares of stock, bonds, options and commodities are considered fairly liquid, because they can usually be sold readily and you can receive the cash within a few days. Each of the above can be considered as cash or cash equivalents because they can be converted to cash with little effort, although sometimes with a slight penalty.

We are concerned about liquidity because cash is a company's lifeblood. In other words, a company can sell lots of product and have good net earnings, but if it can't collect the actual cash from its customers on a timely basis, it will soon fold up, unable to pay its own obligations.

Measures of company liquidity:

Several ratios look at how easily a company can meet its current obligations. One of these is the current ratio, which compares the level of current assets to current liabilities. Remember that in this context, "current" means collectible or payable within one year. Depending on the industry, companies with good liquidity will usually have a current ratio of more than two. This shows that a company has the resources on hand to meet its obligations and is less likely to borrow money or enter bankruptcy.

A more stringent measure is the quick ratio, sometimes called the acid test ratio. This uses current assets (excluding inventory) and compares them to current liabilities. Inventory is removed because, of the various current assets such as cash, short-term investments or accounts receivable, this is the most difficult to convert into cash. A value of greater than one is usually considered good from a liquidity viewpoint.

One last ratio of note is the debt/equity ratio, usually defined as total liabilities divided by stockholders' equity. While this does not measure a company's liquidity directly, it is related. Generally, companies with a higher debt/equity ratio will be less liquid, as more of their available cash must be used to service and reduce the debt. This leaves less cash for other purposes.