Liquidity: Definition, Ratios and Terms for Calculation of Liquidity Ratios
Liquidity is the company's ability to pay off its short-term obligations based on ratio calculations.
Companies need analysis of financial statements in their business activities, this is also related to the liquidity capacity of a company.
Liquidity in question is related to the overall financial condition of the company but also how the company is able to turn current assets into cash.
Definition of Liquidity
Liquidity is the company's cash and to see how the company is able to pay off short-term obligations. Liquidity or also known as the liquidity ratio is used as a measure of creditors regarding the return of a given debt.
This is based on the assessment that if an entity is unable to fulfill its short-term obligations, it is naturally impossible for its long-term obligations to be fulfilled.
The liquidity ratio focuses on the relationship between current assets and current liabilities, where the two assets that most influence a company's liquidity and profitability are receivables and inventories.
The liquidity ratio concerns the company's ability to pay its short-term obligations, based on the liquidity ratio there are four items that show the company is able to pay off its obligations.
- Current ratio=current assets / current liabilities
- Quick ratio = (cash + marketable securities + receivables) / current liabilities
- Cash ratios = (cash + marketable securities) / current liabilities
- Working capital = Current assets - current liabilities
Companies that have large liquid assets will be able to pay off their obligations and vice versa, companies that do not have sufficient liquid assets are considered not to have sufficient assets to pay off their obligations.
Terms of Liquidity Ratio Calculation
As explained regarding the liquidity ratio, there are a number of items used to measure a company's ability to pay off its obligations. The following is a further explanation of these measurement terms:
- current ratio a term that describes the ratio between current assets and current liabilities. It is usually the most common measure of a company's ability to pay off its short-term obligations. If the ratio of current assets and current liabilities is lower, the company's ability to pay off its obligations will not be fulfilled
- Quick-ratio a term that is also used to describe a company's ability to pay off its obligations. This calculation is done by subtracting current assets from inventory, this is because inventory is part of current assets with low liquidity and experiences price fluctuations.
- Cash ratio the term used to describe the company's cash capacity in current liability management, this ratio is used to indicate the cash position that is considered to be able to cover current debts.
- working capital a term relating to all current assets, the difference between the total current assets and current liabilities and the function of funds in obtaining profits by the company. The greater the funds used in working capital, the profit will also increase.
We know now that liquidity can be considered as an item to assess whether a company will be able to pay its short term obligations. Hopefully this information will help add to your insight regarding the meaning of liquidity and its relation to a company's business.