Liquidity - what is it? Types and examples

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

Evaluation of financial indicators is carried out by each enterprise. This allows you to determine the positive and negative aspects of the organization of production activities. One of the important indicators of financial analysis is liquidity. This is a coefficient that can characterize working capital. On the basis of it, conclusions are drawn about the solvency of the company, its stability. The essence and methods of calculating this indicator will be discussed further.

General definition

Liquidity is an indicator that characterizes the availability of cash and other own resources at the enterprise, which can be converted into cash in a short time and pay off debts. This concept is applicable to different economic categories, such as balance sheet, property, enterprise, etc.

Each company owns equity and debt. The first type of capital includes various assets. It is characterized by different market value and speed of implementation. The faster you can sell an asset, the more liquid it is. Moreover, its price should be as close as possible to the market level.

Money is the most liquid. Securities are slightly inferior to them. However, it is also a liquid asset. It can also be accounts receivable and other property. Liquidity assessment is carried out according to the indicators of the balance sheet. This allows you to draw certain conclusions about the state of the enterprise, its solvency and the possibility of development in the future.

Types of assets

Liquidity indicators are calculated for different groups of balance sheet assets. They fall into three categories. The company must have highly liquid assets. These include money, bank deposits, deposits, stocks, foreign exchange, stocks, and government-issued securities. Such values can be realized quickly, in just a few hours.

Medium liquid assets represent capital, which is formed by receivables, finished products. This category of property does not include doubtful and uncollectible receivables. Such assets can be converted into cash within 1-6 months. During this time, their value will not decrease significantly.

Low-liquid assets are machinery and equipment that are obsolete. It also includes overdue receivables. This category includes property that can only be sold at market value over a long period of time. Moreover, it should be noted that the liquidity assessment is carried out for each item of the balance sheet separately. The same unit of property of different enterprises may differ in different degreesliquidity.

Features of asset liquidity

Liquidity is an indicator that can be estimated rather conditionally. The same type of assets may differ in different speed of implementation. So, for example, the shares of a successful company are sold in a matter of minutes, almost instantly. But the same securities of a new, little-known company will be sold indefinitely. This process may take months.

In the process of trading, the value of an asset may decrease. Therefore, it is important to sell it quickly. Otherwise, it will gradually depreciate. Shares of a little-known company may be freely available for several months. During this time, they will lose about 30% of their original value. Therefore, companies are interested in their assets being liquid.

An elite cottage outside the city will be low-liquid. It is expensive, for a comfortable stay it requires a car. Also, not all buyers can afford such a house. It will be difficult to implement. But a two-room typical apartment is sold in just a few days. Its cost is relatively small. At the same time, the circle of buyers of such real estate is wide. Therefore, the definition of liquidity is approached individually.

Profitability and solvency

Calculation of the liquidity of the balance is carried out in order to determine the structure of the company's funds. Based on the data obtained, they draw conclusions about whether the company will be able to pay off its debts, and also stay afloat even inunfavorable conditions. The higher the liquidity, the higher the solvency.

If a company has enough funds to pay off current debts, it can be considered financially sound. The risk of non-repayment of funds to creditors is significantly reduced. This allows you to attract third-party resources to develop your business, finance turnover.

However, profitability and liquidity are not related. A company may have equipment on its balance sheet that is difficult to sell if necessary. However, her income can remain consistently high, covering existing costs. If the liquidity is high and the profitability of the company is low, then the funds are used inefficiently. The company has enough resources to maintain a stable operation, but the decisions of the leaders lead to the fact that they are applied irrationally.

Assets

The liquidity of the balance sheet is determined by a special method. Data for the study are taken from the financial statements for several periods. This allows you to evaluate changes in dynamics. The information for the calculation is in the balance sheet of the enterprise. It is customary to divide it into 4 groups.

The first category (A1) includes cash. These are the most liquid assets. The second category (A2) includes quick liquid assets. This is a receivable. Its maturity is not more than 12 months. Doubtful accounts receivable are excluded from this category.

The third group (A3) includes slowly liquidresources. These are doubtful or overdue receivables, inventories, work in progress. Hardly liquid assets (A4) are non-current assets. These are equipment, buildings and structures. They have a specific purpose and high cost. Therefore, it will be much more difficult to sell them than the previous categories of property.

Balance

Since the data for calculations is taken from the financial statements, they must be considered comprehensively. The balance has two parts. Liabilities reflect financial resources. These are the sources from which the company received its capital. The asset also includes the articles on which these resources were spent. Therefore, these two sides of the balance coincide. These are two sides of the same coin.

The liquidity ratio of the balance is calculated in accordance with its structure. Balance categories from A1 to A4 are compared with liabilities. In this part of the balance sheet, the sources of financing are also grouped according to their maturity dates. The fastest way is to pay off current obligations to creditors. This is group P1. The second category (P2) includes loans with a maturity of less than one year.

The third group includes long-term liabilities (P3). They can be repaid after a few years. The fourth category (P4) includes equity capital. It doesn't need to be redeemed at all. The enterprise will be liquid if inequality is preserved when comparing groups:

A1>P1

A2>P2

A3>P3

A4<P4.

This is a simple rule that an analyst must evaluate. If violations are identified, the cause of such a phenomenon is established.

Current liquidity

It is also called general and characterizes the speed of realization of the entire amount of the organization's current assets. This is the most common indicator. It shows whether the company is ready to pay off current debts that arise during one period. This formula looks like this:

TL=OS / KZ, where OS - current assets (average value for the beginning and end of the period), KZ - short-term loans (obligations that need to be settled in one year).

Since the calculation is based on financial statements, the formula will look like this:

TL=(s. 1231+…+s.1260) / s.1500

This indicator allows you to look at the situation in general. Trends. Which have developed in it, you need to consider separately. There are techniques that allow you to assess liquidity from a different point of view. It is divided into separate categories.

Normative

Coefficient current. liquidity is compared with the standard. It is determined for each industry separately. For most enterprises, this indicator should be in the range of 1.5-2.5. This is the optimal value, which shows that the company has enough funds to cover its current obligations.

If during the analysis it was found that the current liquidity ratio fell below 1.5, this indicates an insufficient numberliquid assets. If the need arises, the company will not be able to fully pay off debts. Attention should be paid to reducing the amount of debt and increasing the number of current assets.

If the indicator of the stopped value is significantly exceeded, we can talk about the inappropriate use of resources by the company. She has a lot of her own money in circulation. In this case, the company does not effectively use borrowed capital. She does not expand her business, does not work more harmoniously.

Quick liquidity

There is another formula for the liquidity ratio. It allows you to calculate the number of quickly sold assets in working capital, as well as compare them with funding sources. So, quick liquidity is calculated as follows:

BL=(OS - Inventory) / KZ.

Balance calculation will look quite simple. To do this, do the following:

BL=(s.1200 - 1210) / s.1500.

This formula allows you to estimate the number of the fastest selling assets, as well as compare them with the organization's current liabilities. This indicator also has a standard. It must not be less than 1.

Deciphering the result

The liquidity formula allows you to draw a conclusion about the state of quickly realizable assets, as well as their ability to cover debt. If this indicator decreases to the level of 0.7, this will indicate a decrease in the company's ability to pay its creditors for the use of their funds.

It is also worth noting that with a lack of liquidassets, the company will not be able to take out a loan on favorable terms. As the risk of investors and borrowers increases, the cost of using their capital also increases.

If the indicator is greater than 1, this is a positive characteristic of the organization's activities. This indicates an increase in solvency. The company receives a high credit rating. She can easily pay off her obligations.

Most liquid funds

Absolute liquidity is an indicator that characterizes the ability of an enterprise to repay part of its credit debt in the shortest possible time. All the company's money, which is currently in cash or non-cash form, is taken into account.

This indicator reflects the part of credit debt that can be repaid with the most liquid resources. This indicator is rarely used in practice. Many companies do not store their resources in the form of cash or non-cash funds. They are put into circulation. Money is rarely needed urgently, since at the conclusion of the contract the debt repayment period is indicated.

Calculation and standard

The presented balance liquidity formula can be calculated by a bank to determine the solvency of a company that wants to take out a loan. The indicator is calculated as follows:

AL=DS / KZ, where DS - cash (cash, non-cash) funds.

According to the balance, the calculation looks like this:

AL=p.1250 / p. 1500

The standard is 0, 2. The company will not be able to pay off part of the debt instantly ifindicator is less than the limit. When it exceeds the standard, we can talk about an irrational capital structure. The funds are not used in the production activities of the company.

Having considered the main features of the presented indicators, it can be noted that liquidity is one of the most important indicators that is used in the course of the financial analysis of an enterprise.