Liquidity

Liquidity

Liquidity is a quality. It is a measure of a capability. It is a finance term and the definition of liquidity is the capability of meeting the obligations that are going to be due within one financial year. One can assess the liquidity from the Balance sheet figures of the organisation. The period from date at which balance sheet is drawn to date exactly one year afterwards is important from the perspective of the Liquidity. If the company has enough capacity to meet the liabilities due within this period, the company is said to have sound liquidity position.

Liquidity and Short-term Period

In the Table 1, we have supposed the current financial  year end of a Company “Topaz Inc” to be 31st December 2015. This date is a reporting date for the company and the company will prepare and present the Financial statements including the Balance Sheet on this date for the period covering 31st December 2014 to 31st December 2015.

Organization	Current Financial Year End	One Year after Financial Year End
Topaz Inc	31st December 2015	31st December 2016

Table 1 Reporting Date of the Company | Accountinglogics.blogspot.com

This is the point of time to assess the degree of liquidity of the organization. The measure of the liquidity at the current Financial Year end that 31^st December 2015 will cover the period up to 31^st December 2016. This one year period which is the subject of the liquidity is termed as Short-term Period.

Liquidity Risk Management

Liquidity planning deals with the short-term planning. Working capital also deals with the short-term. Liquidity risk management is all about that you manage the company’s short-term cash and liquidity requirements in such a way that working capital operations are not affected at all and the company is able to meet all the short-term obligations that are expected or otherwise unexpected. Liquidity risk management systems helps the company in relation to assessing its potential short-term obligations and the cash and cash equivalents that will be required to settle those obligations. Liquidity risk management is very important if the organization is to be successful in the normal course of business and have sustainability in the future.

Figure I Concept of Liquidity and Liquidity Ratios

Liquidity Ratios

The two important liquidity ratios are current ratio and the Quick ratio. Quick ratio is more reliable benchmark in relation to the Liquidity assessment as it excludes the figure of the inventory in the computation of the Quick ratio. The very name Quick ratio suggests the quick assessment  of the Liquidity. Inventories consume time in converting to the liquid asset that is or receivables.  The interpretation of the Liquidity current ratio and liquidity quick ratio is important. The higher the ratio, the better but it is important to consider that excessively high current ratio may be indicative of high level of investment in the inventory and thus may affect working capital operations. This is why the Quick ratio is more reliable measure of the liquidity.

Computation of the Liquidity Ratios

Current Ratio can be computed by dividing the total current assets figure by the total liabilities figure. The figures can be obtained from the balance sheet of the company. The Quick Ratio computation is similar, however, in the numerator, it is important to deduct the figure of the inventories at the end of the reporting year from the current assets and then dividing the (current assets- inventories) by the current liabilities.