What does liquidity measure? Explain the trade-off a firm faces between high liquidity and low liquidity...

What does liquidity measure? Explain the trade-off a firm faces between high liquidity and low liquidity levels.

Expert Solution

Answer: Liquidity- Liquidity refers to enough cash and cash equivalents with the company.

Liquidity measures- Liquidity measures the ability of a company to pay its short term and long term debts. It is analyzed with the help of these ratios:

Current Ratio = Current assets/Current liabilities

Quick ratio = Liquid assets / Current liabilities

Cash ratio = Cash & Cash equivalents / Current liabilities

High liquidity- High liquidity means, company has enough current assets, cash and working capital to easily pay the debts of creditors. Current ratio between 1 to 3 is good but higher the ratio sometimes show that company has unnecessarily invested into current assets, so current assets are lying idle, the amount would have been invested some where else to get more returns.

Lower liquidity- If company has less cash and its current assets are less than current liabilities, it is not good for company because company is not able to pay its short term debts easily and it will have liquidity crunch.

Conclusion- Company should maintain an ideal current ratio, an optimum level of liquidity where company does not face any liquidity issue and current assets are efficiently and effectively used to pay the short term debts.

jeff jeffy answered 1 year ago

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