What is Liquidity? Functions and Examples

Definition of Liquidity – Has Sinaumed’s ever wondered what liquidity is and how to calculate it using ratios? Check out the following explanation so that Sinaumed’s can find out about how long the company can finance business operations and other benefits that Sinaumed’s will get.

Definition of Liquidity

Before discussing liquidity further, Sinaumed’s needs to first understand the meaning of liquidity. Liquidity is the ability or power of a company to pay debt and short-term obligations. Examples of short-term debt are taxes, trade payables, dividends, and so on.

However, there are also those who say that the definition of liquidity is the ability of individuals and companies to pay off debts or obligations with current assets. If the company does not have the power to pay off its obligations, it will be impossible for the company to be able to carry out operational activities the same as before.

In general, each company has a different level of liquidity as shown in certain figures, such as the quick ratio, current ratio and cash ratio. The higher, the Pert Sinaumed’s that the company has a better performance also in carrying out its operational activities. With a high level, it can attract investors, for example financial institutions, creditors, and suppliers.

The Role of Liquidity

To run a business, there are several obligations that Sinaumed’s needs to fulfill. This obligation is the obligation to pay debts and also the obligation to finance all the operational needs of the company. These two obligations are known as liquidity.

If a company is able to pay these obligations then it can be said that the company’s liquidity is good, but if the company is unable to pay all of these costs then the company can be categorized as a company that is not good.

Therein lies the importance of the role of liquidity, by knowing the ability to pay of a company, the benchmark for the success of SMEs can be assessed.

Liquidity Benefits and Functions

Sinaumed’s needs to know that liquidity in a company has its own functions and benefits for the operating processes of that company. Some of the functions and benefits of liquidity include:

  • As the right media in carrying out the company’s daily business activities.
  • As a tool to anticipate if there is a sudden or urgent need for funds.
  • For companies engaged in finance or finance, it can make it easier for customers to make loans or withdraw funds. Companies can use the help of financial management software to get optimal business management.
  • As a reference for the level of flexibility of a company in obtaining investment approval or other profitable business.
  • A tool that can trigger companies to improve performance.
  • As a benchmark for the company’s ability to pay short-term obligations.
  • Can help management to check the efficiency of working capital.
  • Assist companies in analyzing and interpreting financial position in the short term.

Therefore, maintaining the level of liquidity is important because it can gain the trust of both internal and external parties. With a good level of liquidity, companies can pay employee salaries according to a predetermined date and easily obtain capital loans from investors, banks and other parties.

Components in Liquidity

Furthermore, what Sinaumed’s needs to know is an understanding of the liquidity component. The main components that exist in liquidity can be divided into three parts. Here are the three components:

  • Density is a gap or distance that can explain the price range of a product, including the normal price range and the price range that has been agreed by the company.
  • Depth is a component that describes the volume of sales and purchases of a product at a certain price level.
  • Resilience is an explanation of the speed at which prices change towards efficient prices after price volatility or deviations occur.
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Examples of Liquid Assets and Application of Liquidity Ratios

Sinaumed’s , after we understand about liquidity. However, it certainly feels lacking if we don’t know real examples of liquidity in everyday life. This time, let’s discuss examples of liquid assets and the application of liquidity ratios in their calculations!

Examples of liquid and illiquid assets

1. Cash or Cash

Cash is the most liquid asset because it is related to liquidity, all other assets are valued for their ease of being converted into cash or cash.

2. Limited Cash (Restricted Cash)

Limited cash is a cash deposit as a set aside by the company to meet future obligations. The amount of cash is also quite significant. However, this deposit is considered illiquid if it is legally restricted, such as compensation for a loan.

3. Securities

Securities are financial instruments that can be traded in the public market. Securities liquidity is related to the daily trading volume of these securities. Government bonds that have a high trading volume are considered to be nearly as liquid as cash. Meanwhile, securities that have little value are considered illiquid.

4. Cash Equivalents

Cash equivalents are securities and instruments that can be exchanged for cash, just like commercial paper and bills.

5. Credit

Unused credit such as lines of credit can help entities to achieve liquidity. However, these facilities may be subject to conditions that make credit much less reliable than cash in a liquidity crisis.

For example, in the event of a global financial crisis, banks may have incentives to withdraw credit lines.

6. Assets (Illiquid)

Assets which include inventory, receivables, equipment, vehicles and real estate are not considered liquid because they take a long time such as months or even years to convert into cash. In the event of financial stress, these assets may be more difficult to convert into cash.

Calculating Liquidity Using Ratios

After knowing what liquidity means and its functions and benefits, of course Sinaumed’s wants to know about how to calculate it. To calculate it, Sinaumed’s can use the liquidity ratio formula, so as to find out whether the company’s liquidity is in good condition or not. This calculation can be divided into four types of liquidity ratios, namely:

1. Current ratio

This calculation is used to determine the extent to which the company’s current assets can cover its short-term debt. If the results show a high enough value, the higher the company’s ability to cover its short-term debt. The following is a formula for calculating it with the current ratio:

CURRENT RATIO = CURRENT ASSETS : CURRENT LIABILITIES

If the current ratio is low, such as below 1.2, then this indicates that the company does not have the ability to pay its short-term debt. However, a lower value can also indicate that the company has used its current assets effectively and efficiently.

2. Quick ratio

The quick ratio is used to take into account inventory, which is part of the current assets used to pay off short-term liabilities. This happens because the disbursement of inventory requires a longer time. To calculate the quick ratio, try to use the formula below:

QUICK RATIO = (CURRENT ASSETS – INVENTORIES) : CURRENT LIABILITIES

If the result is more than 1.0, then the value of the company’s ability to pay off short-term debt is considered very good. However, if the value is above 3.0, then the company’s ability will be considered less productive.

This is because current assets are not utilized optimally in other forms of investment or the profit target is not right. Through the quick ratio, Sinaumed’s can see whether the company’s cash flow can run healthily or unhealthy.

3. Cash ratio (Cash ratio)

The cash ratio is a way to measure the amount of cash available and used to pay off the company’s short-term debt. It is recommended that this ratio figure has a comparable figure, between cash and debt, which shows 1: 1.

If the cash ratio is greater than short-term debt, then the value of the cash ratio is good, because there is availability of funds that can be used to pay off these short-term obligations. Here’s how to calculate the cash ratio using the formula:

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CASH RATIO = CASH AND CASH EQUIVALENTS : SHORT TERM DEBT

The meaning of cash and cash equivalents here can include company cash and securities that are easy to liquidate, such as bonds or fundraising when the Sinaumed’s company needs emergency funds.

4. Cash turnover ratio (Cash turnover ratio)

With this ratio, Sinaumed’s can see how many times the company’s cash has circulated in one period as measured by sales. To calculate it, you can use the following formula:

CASH TURNOVER = NET SALES : AVERAGE CASH

If you find a ratio that is getting bigger, then the value of the company’s ability to overcome financial problems will be even bigger.

Examples of Financial Ratio Problems

Quoting from the book Fundamentals of Financial Statement Analysis by Hadijah Febriana, SE, MM, the following is an example of financial ratio questions that can be used for training in understanding material regarding financial ratios.

Example Question 1

From the report on the company, it is known that there are:

Cash and cash equivalents = 100,727,141,756

Total short term liabilities = 408,490,550,651.

Based on the data above, what is the cash ratio of the company?

Answer :

Cash Ratio = Total Cash / Total Current Liabilities

Cash Ratio = 100,727,141,756 / 408,490,550,651

Cash Ratio = 0.246

The value of the cash ratio in the company is 0.246 or 24.6%. This means that currently the company’s cash is only able to cover 24.6% of its total current debt.

Example Problem 2

Total Current Assets = 1,165,406,301,686

Current Inventory = 316,826,909,348

Total Current Liabilities = 408,490,550,651.

Based on the data in the report above, what is the quick ratio of company X?

Answer :

Quick Ratio = (Total Assets – Inventory) / Total Current Liabilities

Quick Ratio = 91,165,406,301,686 – 316,826,909,348) / 408,490,550,651

Quick Ratio = 848,579,392,338 / 408,490,550,651

Fast Ratio = 2.08

The value of the quick ratio owned by company X is 2.08 times. Which means, company X has the ability to pay off its obligations in the short term which is quite good and is not excessive in investing its current assets.

The figure 2.08 also shows that every Rp1 of the company’s current liabilities can be guaranteed by current assets of Rp2.08.

Example Problem 3

A company has total assets of 1,165,406,301,686 and total current liabilities of 408,490,550,651. Based on these data, how much current ratio does the company have?

Answer :

Current Ratio = Total Current Assets / Total Current Liabilities

Current Ratio = 1,165,406,301,686 / 408,490,550,651

Current Ratio = 2.85

Example Problem 4

Beginning of the Year Cash = 64,106,808,475

Cash End of Year = 100. 727,141 756

Net Sales = 3,512,509,168,853

Based on the reports mentioned earlier, what is the cash turnover ratio?

Answer :

Average Total Cash = (Total Cash at Beginning of the Year + Cash at the End of the Year) /

Average Total Cash = (64,106,808,475 + 100,727,141 756) / 2

Average Total Cash = 164,833,950,231 / 2

Average Amount of Cash = 82,416,975,155.5

After obtaining the average total cash, the cash turnover ratio is as follows:

Cash Turnover Ratio = Net Sales / Average Amount of Cash

Cash Turnover Ratio = 3,512,509,168,853 / 82,416,975,155.5

Cash Turnover Ratio = 42.62

Based on these results it can be seen that the cash turnover ratio of PT. Siantar Top Tbk in 2019 was 42.62 times. Which means, during 2019, cash from this company has rotated more than 42 times a year.

This shows that the conversion of current assets into cash through sales is relatively fast.

Example Problem 5

A company has financial reports and balance sheets that contain the following data:

Total Current Assets = 1,165,406,301,686

Current Inventory = 316,826,909,348

Total Current Liabilities = 408,490,550,651.

Based on the data above, what is the net working capital stock ratio?

Answer :

Net Working Capital Inventory Ratio = Current Inventory / (Total Current Assets – Total Current Liabilities)

Net Working Capital Stock Ratio = 316,826,909,348 / (1,165,406,301,686 – 408,490,550,651)

Inventory Ratio

Net Working Capital = 316,826,909,348 / 756,915,751,035

Net Working Capital Stock Ratio = 0.42

The value of the company’s net working capital stock ratio is 0.42 or 42%. This implies that 42% of the company’s net working capital is stored in inventory or availability.

Also Read:

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  • Understanding the Definition, Functions, and Types of Money
  • Cash Equivalent Assets: Definition, Types, Purpose