The liquidity ratio helps to assess the cash flow position of the business. It’s a valuable tool in assessing if the business has sufficient liquid resources to meet the liabilities that fall due in the next twelve months.
The most significant risk associated with the liquidity analysis is the risk of liquidation. The risk of liquidation is related to the inability of the business to pay debt obligations, suppliers’ payments, excessive losses, and some unusual outflow of the cash resources.
Also read, gearing ratio, profitability ratio.
Detailed explanation
The success of any business is dependent on effective cash/liquidity management. Even liquidity is a more critical factor for the financial analysis as business success is more dependent on the cash flows. It has been noted that more business failures in the world are due to mismanagement of cash flow rather than problems with profitability.
So, an assessment of the liquidity position is closely connected with the going concern status of the business. If the liquid resources available within the business are sufficient, it leads to fewer chances of the business liquidation and vice versa.
The liquidity position is assessed by using two well know ratios. These ratios include the current ratio and the quick ratio. The current ratio compares the current assets of the business with current liabilities. It’s desirable to have a current ratio greater than one because it indicates sufficient liquid resources are available within the business to meet the liabilities that fall due.
The formula to calculate the current ratio is given below,
Current ratio = current assets/current liability
The same goes for the quick ratio. However, the difference is that the quick ratio does not consider inventory as a current asset and has to be deducted for the same reason. The logic behind using a quick ratio is that inventory may not always be liquid to be converted into cash.
The formula to calculate the quick ratio is as follow,
Quick ratio = (current assets – inventory)/current liability
Working capital management and liquidity
Working capital management of the business is an essential factor of effective business operations. If the business cannot operate a working capital cycle, it might lead to losses on account of fixed costs. Further, there is a close connection between working capital and liquidity. The relationship can be analyzed by the fact that liquidity and working capital use the same account balances.
So, the better liquidity position of the business helps to ensure the availability of sufficient working capital and vice versa.
The liquidity ratio must not be confused with the solvency ratios. Liquidity assessment is about being able to meet the current liabilities that fall due. On the other hand, solvency is the ability of the business to generate cash flows and meet the long-term debt in the finance structure of the business.
Conclusion
The liquidity ratio measures the ability of the business to meet current obligations that fall due. If the business has higher liquid resources, it’s considered a financially prosperous business with the ability to meet the liabilities that fall due in the next twelve months.
Maintaining adequate liability is essential from the financing, and operational perspective of the business as the business without liquid resources may not be able to meet financial commitments, which can lead to problems for overall business management.
