Liquidity

Liquidity

In accounting, liquidity (or accounting liquidity) is a measure of the ability of a company to pay his debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities versus current assets.

Calculating liquidity for a business with a balance sheet is easy and there are various ratios used to calculate or measure liquidity. These include the following: the ' current ratio', which is the simplest measure and is calculated by dividing the total current assets by the total current liabilities. A value of over 100% is normal in a non-banking corporation and would be expected for a healthy business.

However, certain current assets are more difficult to sell and realise for cash at full value in a hurry so an alternative is to use the 'quick ratio' which is calculated by deducting stock (inventory) and prepayments from the current assets figure and then dividing this net total by the same current liabilities amount. This liquidity ratio gives the user a better measure of the ability of the company to meet it's current liabilities from the assets that can be readily sold and includes cash and amounts due from customers.

The best way for a trading company to meet it's liabilities is from cash flows, rather than through asset sales or from bank loans or overdrafts or from additional share investment. Which leads on to the 'operating cash flow ratio' which is calculated by dividing the operating cash flow by current liabilities and indicates the ability of the business to service current debt from current income, rather than through asset sales.

Liquidity in banking has recently been a big concern in a banking environment and a shortage of liquidity has often been a trigger for bank failures, whereby we have seen governments stepping in to shore up the banking system. Holding assets in a highly liquid form tends to reduce the income from that asset (cash, for example, is the most liquid asset of all but pays no or low interest) so banks will try to reduce liquid assets as far as possible.

However, a bank without sufficient liquidity to meet the demands of their depositors risks experiencing a bank run. The result is that most banks now try to forecast their liquidity requirements and maintain emergency standby credit lines at other banks. Banking regulators also view liquidity as a major concern.

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