Accounting Liquidity

From Financial Literacy Wiki

Accounting liquidity (liquidity) is a measure of the ability of a debtor to pay their debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities.

Calculating liquidity

For a corporation with a published balance sheet there are various ratios used to calculate a measure of liquidity. These include the following:

• the current ratio, which is the simplest measure and is calculated by dividing the total current assets by the total current liabilities. A value of over 100% is normal in a non-banking corporation. However, some current assets are more difficult to sell at full value in a hurry, so;
• the quick ratio - calculated by deducting inventories from current assets and then dividing by current liabilities - gives a measure of the ability to meet current liabilities from assets that can be readily sold. A better way for a trading corporation to meet liabilities is from cash flows, rather than through asset sales, so;
• the operating cash flow ratio can be calculated by dividing the operating cash flow by current liabilities. This indicates the ability to service current debt from current income, rather than through asset sales.

Understanding the ratios

For different industries and differing legal systems the use of differing ratios and results would be appropriate. For example, in a country with a legal system that gives a slow or uncertain result a higher level of liquidity would be appropriate to cover the uncertainty related to the valuation of assets. A manufacturer with stable cash flows may find a lower quick ratio appropriate than an Internet-based start up corporation.