Understanding Liquidity – Liquidity is one of the important factors in the sustainability of a business. Of course, a company must have enough funds to meet its financial obligations aka debt. Therefore, we certainly need to have cash. Even so, too much cash will dilute the opportunity to invest and support the growth of the company.
Related to that, we need to understand the meaning of liquidity, because measuring liquidity can help to find the right balance and monitor the financial “health” of a company. As a result, our business can be helped and grow even more.
Not only that basic thing, liquidity is also important when we apply for a funding or loan. Because, banks and investors will pay close attention to the liquidity ratio when considering the ability of a company to repay its debt.
This is certainly a good reason for us to immediately learn liquidity, starting from the basics. But before that, what is the theoretical meaning of liquidity? Let’s take a look at the discussion below related to the meaning of liquidity to examples and its role in investment!
Definition of Liquidity
The notion of liquidity in general actually has two meanings. In a company, liquidity is one of the important factors to determine the condition or sustainability. Therefore, many business actors use liquidity as a yardstick or benchmark to assess the company’s ability to finance the needs or operational activities of the company.
As we know, the notion of liquidity in accounting and financial analysis is a measure of how easy and possible it is for a company to meet short-term obligations, such as business debts, dividends, taxes, and others, by using current assets.
For example, we may see that there is still enough cash to cover current and future bills as we expect. Or, we may need to take advantage of investments and other assets that can be converted into cash. The easier it is to convert an asset into cash, the more liquid the asset is.
For example, there is a shop that sells collectible stamps. The shop may reserve its inventory for the right buyer to get the best price, meaning the stamp is not very liquid. However, if the same stamp shop owns stocks or bonds, both can be sold quickly so that the investment is considered liquid.
In financial markets, this term refers to how quickly an investment can be sold without causing a negative impact on its price. If we know that an investment is more liquid, it means that the investment can be sold faster, and vice versa.
With the availability of liquidity, it is possible that assets that are assessed as more liquid will be traded at a higher price because of the profit they carry. Meanwhile, illiquid assets are traded at lower prices.
Be aware, companies use assets to run their business, including producing goods or creating value in other ways. Assets can include things like equipment or intellectual property. Meanwhile, supplies or products sold by companies to generate income are usually considered current assets because they will usually be sold within one year.
For an asset to be considered liquid, it needs to be in an established market with many interested buyers. Moreover, the asset must also have the ability to transfer ownership easily and quickly.
The information we need to check liquidity can be found in the company’s balance sheet. Because assets are usually listed in the order of how quickly they can be converted into cash. So, at the top of the balance sheet is cash, the most liquid asset.
In this balance sheet, the liabilities or debts of our company are also listed. Obligations are listed in the order of when they will fall due. Bills that must be paid first are listed at the top.
Comparing short-term liabilities with cash and other liquid assets can help us better understand the financial position of the business. Afterwards, we can increase the company’s liquidity with certain ratio numbers, such as current ratio, quick ratio, and cash ratio.
In short, a company’s high liquidity can trigger investor attraction. They will consider it as something positive, that our company is financially healthy and has a small risk of loss. Even in the stock market, companies with these characteristics are called blue chip stocks .
Judging from various sources, these are the various functions of the company’s liquidity.
- Become an anticipator of funds when the company is faced with sudden needs.
- Measuring the availability of cash and cash equivalents to meet short-term debt obligations.
- As a matter of consideration regarding the eligibility of a company in receiving an injection of funds from capitalists.
- Supporting the running of daily business activities.
- Facilitate the withdrawal of customer funds on behalf of the bank.
- Can help company management in overseeing capital efficiency.
- As an aid in analyzing and interpreting the company’s short-term financial position.
- Act as a trigger for the company in improving the work of its employees.
Types of Liquidity Ratios
Ratio, in terms of accounting, is the relationship between two financial variables that are systematically related to each other. Therefore, the analysis of the ratio obtained from the calculation process and the results of the ratio can be used as material to make a decision on the agreement of a company.
As for the three most important ratios to measure liquidity, namely:
1. Smooth Ratio
The current ratio is a number used to show how large the company’s ability to meet its current obligations by using current assets. In addition, this ratio can be used as a comparison between current assets and current liabilities.
The method used to find out the level of the company’s current ratio alias current ratio is quite simple, namely by observing the amount of the company’s current assets such as cash, receivables, supplies and other current assets.
If current assets have a larger amount than current liabilities, then the company has a high current ratio. The higher the current ratio, then it can be ensured that the company has the ability to pay off its debts or obligations.
This ratio calculates the company’s current assets against its current liabilities. This determines whether the company can pay off all its short-term debts with the money received from the sale of assets.
Formula used: Current Ratio = Current Assets/Liabilities or Current Debt
2. Quick Ratio
The quick ratio is a ratio that shows how large the company’s ability to pay off its short-term debt without including the value of the company’s inventory. A special feature of this quick ratio is that it only uses cash and other cash equivalents for its calculation.
It should be noted that the quick ratio is a ratio that shows how large the company’s ability to pay off its short-term debt by using current assets without including the value of the company’s inventory.
This is because inventory takes a relatively long time to be converted into an asset, so the company sets aside inventory first. The calculation of the liquidity level with the quick ratio only uses tangible assets such as cash and securities as the main component.
If the quick ratio is at the top, then the financial condition should be in a stable condition. This shows that it will be easier for the company to pay off its short-term debt with good financial conditions. Similar to the current ratio, only this quick ratio only considers receivables, cash, and bonds or stocks as assets.
This is the formula: Current Assets = Current Liquid Assets/Total Liabilities
3. Cash Ratio
This cash ratio is equal to cash divided by current liabilities. The calculation of this ratio will be useful when the company can only use its money to pay off debt. If the cash ratio is 1 or greater, it means that the business has a lot of liquidity and may not face problems in paying its debts.
The formula is Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments)/Liabilities or Current Debt
4. Cash Turnover Ratio
This cash turnover ratio is used to give an overview of the amount of profit a company gets from working capital expenditure. As for the cash turnover ratio, it can show a relative figure which is the result of the total sales of products and working capital. The calculation of cash turnover ratio can be seen from the division of product sales figures with net working capital.
The result of this cash turnover ratio is the profit that the company has achieved from the amount of products sold and its working capital. The amount of this revenue should be greater than the debt to obtain good liquidity.
Formula: Cash Turnover = Sales/Average Cash and Cash Equivalents
5. Working Capital Ratio
Enterprises must be related to working capital. Therefore, in a company, the working capital ratio will be needed to know the picture of their liquidity level. This ratio is seen through assets and working capital positions that can finance the company’s operations.
The calculation of the working capital ratio is done by comparing the company’s total assets with its liabilities. Then, divided by the total assets
The Importance of Liquidity in Business
At this stage, we certainly already know that liquidity is one of the most important factors in the sustainability of a business. However, there are still some things we need to understand about the importance of this liquidity. Let’s watch together!
Good liquidity can be a way to bring together businessmen with the right investors or short-term borrowers. The company will be able to present their efforts with a good effect if they have high liquidity.
Internally, the company also knows their financial status, is it good or bad, risky or not?
The Role of Liquidity in Investments
Besides in business, liquidity is also very important in investing, Reader. We certainly don’t want to give funds to unreliable companies, right? Consideration about their liquidity needs to be done to ensure that our investment is not wasted, especially for the long term.
Here are some focus on the role of liquidity in financial planning:
1. As a Deviation for Cash Proposal
We are advised to set aside a small amount of cash for emergencies, regardless of our total investment in non-liquid assets. Although the amount of this small reserve varies for each person depending on their short-term needs, the general advice is to save three months’ worth of income for this.
2. Balancer between Liquid and Illiquid Investments
Ideally, liquid assets such as mutual funds, shares, bonds, and other alternatives should be properly allocated while the rest is deployed for non-liquid assets. As we know, liquid assets can be converted into cash precisely. This is exactly what we need in saving some wealth.
Even if we don’t invest, we definitely need a cash reserve . So, it is necessary to consider having liquid assets that can be saved depending on our monthly budget and various other factors.
Examples of Liquid Assets and Liquidity Ratio Application
Reader, now we understand about liquidity. However, it certainly feels less if we don’t know real examples in the field. This time, let’s discuss an example of an asset that is liquid and the application of the liquidity ratio in its calculation!
Examples of liquid and illiquid assets
1. Cash or Cash
Cash is the most liquid asset because in relation to liquidity, all other assets are valued for their ease of conversion into cash aka cash.
2. Restricted Cash ( Restricted Cash )
Restricted cash is a cash deposit as a deviation made by the company for future obligations. This amount of cash is also significant. Even so, these deposits are considered illiquid if they are legally restricted such as compensation for loans.
3. Valuable Letters
These are financial instruments that can be traded in the public market. The liquidity of the securities is related to the daily trading volume of the securities. Government bonds with high trading volumes are considered almost as liquid as cash. Meanwhile, securities with a small value are considered illiquid.
4. Cash Equivalent
Cash equivalents include securities and instruments that can be exchanged for cash such as bills and commercial paper.
Unused credit such as lines of credit can help entities to achieve liquidity. Even so, such facilities may be subject to requirements that make them far less reliable than cash in a liquidity crisis. For example, in the event of a global financial crisis, banks may have an incentive to withdraw credit lines.
6. Assets (Illiquid)
Assets such as inventory, receivables, equipment, vehicles, and real estate are not considered liquid because they require months to be converted into cash. In the event of financial stress, the asset may be difficult to convert into cash at all.
Examples of Liquidity Ratio Application
S&S Company has received building materials and other supplies from vendors to complete a project. This vendor certainly hopes that S&S can pay in full after the project is completed. At some point after S&S is close to completing the project, the company must ensure that they have enough money to pay off the loan from the vendor.
Unfortunately, S&S realized that their income was not enough to pay the vendors, so they decided to liquidate some of their current assets. Meanwhile, the ratio used to calculate their ability to repay vendors is the quick ratio.
S&S found that they have current liabilities of USD400 thousand, USD100 thousand in cash, USD100 thousand in securities, and USD300 thousand in receivables. Here’s how to calculate it:
Current Assets = Current Liquid Assets/Total Liabilities
= Cash + securities + receivables/current liabilities
= 100,000 + 100,000 + 300,000/400,000
With this calculation, S&S can know if their company can still liquidate assets to match and pay off their current debt.
Reader, liquidity is very important, isn’t it, in the smooth operation of the company? Not only liquidity, other accounting concepts are of course also needed. Not only in the aspect of business, everyday life even the law will require the concept of accounting in some of its activities!