What is liquidity? Liquidity ratio: balance sheet formula

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

Modern market conditions of the economy are specific and characterized by the impact of the crisis on the activities of companies. Any entrepreneur and businessman wants to deal only with companies that can fulfill their obligations on time. Therefore, the answer to the question: "What is liquidity?" is quite significant. In this regard, it is necessary to clearly understand the main parameters characterizing the financial condition of the company. Consider the concept of liquidity: what is it in a simpler sense, what are the types and what indicators are used to assess it.

The definition under study indicates the ability to quickly sell an asset (at a price as close to the market price as possible). There is another meaning - the ability to easily turn into a money supply. In the process of researching the state of the financial sector of the company, the concept of current and absolute liquidity ratio is mentioned.

Liquidity concept

So what is liquidity? This issue is very relevant today.

Liquidity is a special term that characterizes the value of financial assets. She showsthe ability of assets to be sold at market prices. That is, liquid value means that which is converted into monetary amounts.

Representatives of different industries estimate the standards of this indicator differently, based on the predominance of certain assets, the degree of their value on the market at the moment. The asset liquidity indicator can indicate the level of safety in case of a market crisis.

The concept under study allows you to most accurately determine the financial position of the company, as well as find out the solvency of the organization.

It gives creditors and investors an idea of where the company is in terms of being able to repay its debts.

The meaning of the concept of liquidity

The indicator is very important for investors and counterparties. Indeed, the amount of risk and profitability depends on the liquidity of assets. And the quality of the investment portfolio is determined by the tactics and strategy of investments, not to mention financial stability.

Aims of analysis

The purpose of the analysis, when examining the question of what is liquidity, is to assess the ability of a firm to meet its short-term obligations through existing current assets at a specified time and with specific amounts.

The concept under study is the central indicator of the analysis of the financial condition of the organization. It assumes the ability of the company to pay its debts on time and assesses the degree of bankruptcy of the company. Liquidity analysisis a defining moment in forecasting the activities of the company.

Balance sheet assets by degree of liquidity

The ability of working capital to turn into cash in a short time ensures the solvency of the company in the present and future.

The liquidity of the balance sheet reflects the ratio of existing assets to current liabilities, or rather determines the ability to pay off debts within a certain period of time for the money that will be received from the sale of existing property.

For this purpose, 4 groups of assets are used and allocated:

A1 - can be sold as soon as possible (high liquidity);

A2 - sold up to 12 months;

A3 - remaining current assets;

A4 - Sold for a very long time.

At the same time, liabilities are grouped according to their maturity:

P1 - urgent obligations to creditors, employees, the state budget, etc. that require quick payment;

P2 - credit and borrowed resources up to 1 year;

P3 - credit and borrowed resources for more than 1 year;

P4 - equity (permanent).

A company will be liquid when the first three groups of assets matter more than the first three groups of liabilities, and the last - vice versa.

Various liquidity ratios and balance sheet formulas are used as tools to determine liquidity. They are calculated based on datapresented in the financial statements, using special formulas. Liquidity ratios provide an opportunity to understand whether a company will be able to pay its existing debt without attracting third-party funds, and to predict the future financial position.

Let's consider these coefficients in more detail.

Cover Ratio (or Total Current Liquidity)

The liquidity ratio (balance sheet formula) shows the company's ability to repay debts that need to be closed in the near future. This is the most common liquidity calculation option. Initial information is taken from the balance:

Kp=OA / TO, where Кп is the current coefficient value;

OA - current assets;

TO - current liabilities.

It is also possible to calculate the indicator using the groupings indicated earlier:

Kp=(A1 + A2 + A3) / (P1 + P2).

Its allowable value is determined by the standard from 1.5 to 2.5. If the value of the indicator is less than 1, the firm cannot consistently fulfill its obligations. However, a number greater than 3 indicates an unreasonable use of available resources.

Quick Ratio

It reflects the company's actual ability to pay debts without using its reserves, for example, in the event of problems with the sale of products. The calculation is carried out according to the formula:

Kb=(TA - 3) / TO, where Kb is the quick ratio;

TA - current assets;

З - stocks;

TO - current liabilities.

Or:

KB=(A1 + A2) / (P1 + P2).

Indicator must be greater than 1.

Absolute liquidity ratio

This is the ratio of cash and non-cash funds that the organization currently has to its urgent debts. In practice, this indicator was not used, since it is customary to invest the bulk of the money in the production process. Moreover, when drawing up loan agreements, repayment conditions are provided. However, to calculate a bank loan, it may be necessary to determine it using the formula:

Cal=A1 / (P1 + P2).

In the national economy, the norm is the value of this coefficient equal to 0, 2.

Types of liquidity

Let's consider the main types of liquidity in relation to different options.

• Market liquidity. It is envisaged that the described indicator of the market is influenced by the difference between the offer price and demand, the number of goods involved in transactions, and the stability in making purchase and sale transactions. The indicator is evaluated comprehensively, since fluctuations in an individual market characteristic have little effect on self-sufficiency.
• Bank liquidity. When issuing a loan, the amount of cash that is placed in the bank decreases. With an increase in the volume of loans issued, the probability of their non-payment increases, which means that the bank's liquidity is assessed as low. To increase it without harming the core business, the bank forms reserves. ATin difficult situations, banking organizations have the opportunity to receive a loan from the Central Bank and increase their performance.
• The company's liquidity. Here we are talking about the ability of the company to be liable for obligations by selling assets at its disposal, as well as by raising money from outside (loans).

Solvency and liquidity

Solvency implies that the company has sufficient cash or cash equivalents to pay receivables promptly.

What is liquidity? This is the ability of the enterprise to cover debts within a certain time, which determines the expected state of payments. It is inextricably linked with the concept of profitability - profitability, the provision of which is possible even with low liquidity. Conversely, a company that has high liquidity with low returns may go bankrupt in the near future.

Thus, the concepts of liquidity and solvency are closely related, but at the same time, they also differ from each other.

Fortification directions

The main ways to increase the company's liquidity are:

• increase in equity;
• sale of part of fixed assets;
• decrease in excess reserves;
• long-term funding opportunity.

To strengthen the company's solvency it is necessary:

• improving the management of accounts receivable and accounts payable of the enterprise;
• increase in liquidity balance;
• optimization of accounts payable regulation processes is connected, first of all, with the control of the turnover of funds in settlements: its acceleration is a positive trend in the economic activity of the enterprise.

Turnover acceleration can be achieved by screening potential buyers, defining payment terms, controlling the timing of receivables and influencing debtors.

Optimization of accounts payable management processes includes:

• the right choice of the form of debt (bank or commercial) in order to minimize interest payments and the cost of acquiring material assets;
• creating the most convenient form of a bank loan and its term;
• preventing the formation of arrears associated with additional costs (fines, pen alties).

Delay in receiving information about the amount of debt leads to the fact that the company will either be left without the necessary working capital, or will not be able to correctly plan the amount of money for upcoming payments.

Conclusion

Liquidity is an important factor in the company's economic activity, which plays an important role for investors who want to invest their funds as efficiently as possible. But even people who are far from business need to understand the basic meanings of this concept in order totrust the investments of proven highly liquid companies. Liquidity analysis is a measure of a company's financial ability to pay its debts to creditors, so its analysis and research is a very important step in assessing the company's financial position.