What is Liquidity in Accounting?
Contents
Accounting liquidity is a business’ capacity to cover its short-term liabilities with its most liquid assets like cash, cash equivalents, inventory, and account receivables. This demonstrations how financially secure a company is by showing its ability to meet its short term obligations without liquidating any long-term assets.
Accounting liquidity is different for the traditional concept of liquidity, which often refers to cash itself, as it involves other assets that can be turned into cash in a short period of time.
Accounting Liquidity Formula
The accounting liquidity formula is calculated through several different liquidity ratios listed below:
Current Ratio
The current ratio compares the current assets to current liabilities in an effort to measure a firm’s ability to pay its short term obligations with only current assets like cash and accounts receivables. Here is the current ratio formula.
Current Ratio = Current Assets / Current Liabilities
Quick Ratio
The quick ratio compares only the most current assets ( cash, cash equivalents, and A/R ) to a company’s current liabilities. These are the assets that a company an quickly convert into cash if needed. This ratio measures how able the company is to pay off its current obligations with only these ultra current assets. Here is the quick ratio formula.
Quick Ratio = (Cash + Cash Equivalents + Account Receivables) / Current Liabilities
Operating Cash Flow Ratio
The operating cash flow ratio compares the operating cash of the company with its current liabilities. This shows whether the company can pay its current obligations with only its operating cash and none of its other current assets. This is the most strict of the liquidity ratios. Here is the operating cash flow formula.
Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
Where:
Current Assets: The sum of all the assets of a company that can be turned into cash in a period of less than 12 months.
Current Liabilities: The sum of all the financial commitments of the company that are due in 12 months or less.
Operating Cash Flow: The result of adding back non-cash items to the business’ net income plus the net change in its working capital.
The three metrics evaluate the business’ capacity to cover its current liabilities.
The results of each formula indicate how much of the total current liabilities are covered by the different items included in the ratio.
Accounting Liquidity Examples
Pablo is the owner of Fresh Baked, a company that operates 12 bakeries in New York and founded in 1983 by Pablo’s father. He is currently evaluating his company’s liquidity situation and in order to do so, his financial advisor told him it would be wise to apply different financial metrics that will help him in assessing Fresh Baked accounting liquidity.
The latest financial reports of the company show the following information:
(in thousands)
- Cash: $2,301
- Cash Equivalents: $554
- Inventory: $12,403
- Account Receivables: $5,393
- Other Current Assets: $78
- Current Liabilities: $5,401
- Operating Cash Flow: $12,041
With this information we can calculate the three ratios, as follows:
Current Ratio = ($2,301 + $554 + $12,403 + $5,393 + $78) / $5,401 = 3.8
Quick Ratio = ($2,301 + $554 + $5,393) / $5,401 = 1.6
Operating Cash Flow Ratio = $12,041 / $5,401 = 2.2
This means that Fresh Baked is actually in a very favorable position in terms of its accounting liquidity, as it has plenty of current assets to cover for its short term financial commitments. The company appears to be very solid in this sense.
Accounting Liquidity Advantages
The concept of liquidity can sometimes be confused with solvency. Liquidity refers to the availability of cash to cover for expenses and other payments, while solvency refers to an assessment of a company’s capacity to fulfill its financial obligations.
In this sense, a business may appear to be solvent, but it may not be liquid enough to fulfill its commitments. Accounting liquidity, therefore, refers to a business’ capacity to turn its most liquid assets into cash to pay for all the expenses and other disbursements associated to its operations, on time.
The most common metrics employed to assess a business’ accounting liquidity are the Current Ratio, the Quick Ratio and the Operating Cash Flow Ratio. The first two employ information contained in the company’s Balance Sheet to estimate accounting liquidity, while the latter employs information coming from both the Balance Sheet and the Cash Flow Statement.
Analysis and Business Uses
Each of these accounting liquidity ratios can be interpreted as follows: if the result is equal higher than 1, it means that the company has enough current assets, liquid assets or operating cash flow to fully cover its current liabilities. On the other hand, if the result is lower than 1 it means that the business doesn’t have enough assets or cash flow to cover for these commitments.
Nevertheless, each of the ratios should be analyzed separately, as their results have different interpretations. The Current Ratio for example, should always be higher than 1 to make sure the company is sustainable over time. A Current Ratio lower than one indicates that there are no sufficient current assets to cover for the company’s current liabilities, which means that in a period of 12 months the company may struggle to pay for its dues.
On the other hand, a Current Ratio that is too high compared to industry averages may be indicating that the business is failing to allocate its resources into more profitable ventures, as current assets, due to their liquidity, are usually less profitable than long-term investments.
The Quick Ratio differs from the Current Ratio in the sense that it approaches liquidity in a very extreme way, assuming that the inventory of the business and other assets will not be turned into cash in a short period of time. For this reason, a ratio below 1 can be considered adequate in most cases, but a ratio as low as 0.2 or 0.1 can be signaling that the company’s accounting liquidity is in trouble.
Finally, the Operating Cash Flow Ratio indicates the coverage provided by the company’s cash earnings during a certain time period. It is also very rare to find a coverage higher than 1. In any case, a ratio of 0.5 and above can be considered adequate.
In the example above, we can see that Fresh Baked has a comfortable accounting liquidity situation, considering all of the ratios resulted above 1. This is not necessarily positive, as it may be indicating that the company is not being able to adequately invest its money into more profitable operations such as opening new bakeries. The company should work on an expansion plan that employs these excess funds to increase the profitability of the business.
Cautions
These ratios combined provide a good picture of the overall liquidity situation of a business. Nevertheless, they fail to illustrate managers, investors and creditors about the exact moments when certain debts and commitments are due. The only way a company can keep track of such specific information is through a cash budget, which is a financial management tool that is often inaccessible to third parties or outsiders.
