FINANCIAL LIQUIDITY: WHAT IT CONSISTS OF, INDICATORS AND EXAMPLES - DUDAS - 2024

The financial liquidity for companies refers to the ability of a company to use its current assets to meet its current liabilities or short - term. It describes the degree to which an asset or security can be bought or sold quickly in the market without affecting the price of the asset.

Having cash for operation is vital for a business, both in the short term and for long term expansion. Although the total value of assets owned by a company or individual may be high, it could run into liquidity problems if the assets cannot be easily converted to cash.

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For companies that have loans with banks and creditors, the lack of liquidity can force the company to sell assets that it does not want to liquidate, in order to meet its short-term obligations.

Banks play an important role in the market by lending cash to companies, as long as they hold assets as collateral.

What is financial liquidity?

Financial liquidity refers to the ease with which assets can be converted to cash.

Cash is the most liquid asset. However, some investments are easily converted to cash, such as stocks and bonds. Since these investments are extremely easy to convert to cash, they are often referred to as liquid assets.

Assets like stocks and bonds are very liquid, as they can be converted to cash in a matter of days. However, large assets, such as property and equipment, are not so easily converted to cash.

A checking account is liquid, but if you own land and need to sell it, it can take weeks or months to liquidate it, making it less liquid.

Before investing in any asset, it is important to consider the liquidity levels of the asset, as it could be difficult to convert it back to cash. Of course, aside from selling an asset, cash can be obtained by borrowing it.

Banks lend money to companies, taking the companies' assets as collateral to protect the bank from default. The company receives the cash, but must return the original loan amount plus interest to the bank.

Indicators

Current indicator

Also known as a working capital indicator, it measures the financial liquidity of a company and is calculated by dividing its current assets by its current liabilities.

The term current refers to short-term assets or liabilities that are consumed (assets) and paid for (liabilities) in a period of time less than one year.

Current indicator = Current assets / Current liabilities.

The current indicator is used to show the company the ability to pay its liabilities (debt and accounts payable) with its assets (cash, marketable securities, inventories and accounts receivable).

Industry standards vary, but ideally a company has an indicator greater than 1. This will mean that it has more current assets than current liabilities.

However, it is important to compare the indicators with similar companies within the same industry, to get an accurate comparison.

Quick indicator

Also known as an acid test indicator, it is identical to the regular indicator, except that the quick indicator excludes inventory.

Inventory is eliminated because it is more difficult to convert to cash compared to other current assets, such as cash, short-term investments, and accounts receivable. In other words, inventory is not as liquid as other current assets.

Quick indicator = (Current assets - Inventories) / Current liabilities.

An indicator value that is greater than one is considered good from a financial liquidity point of view. However, this depends on the industry.

Operating cash flow indicator

A company is also measured by the amount of cash it generates on top of its liabilities. The money that is left in a company to expand the business and pay shareholders through dividends is known as cash flow.

It measures how well current liabilities are covered by the cash flow generated by a company's operations.

It is the most accurate of the financial liquidity indicators. This is because it excludes accounts receivable, as well as inventories and other current assets.

More than the standard indicator or acid test, it assesses a company's ability to remain solvent in the event of an emergency.

This indicator is calculated by dividing operating cash flow by current liabilities. The higher the number the better, since it means that a company can cover more times its current liabilities.

Cash flow indicator = (cash and cash equivalents + short-term investments) / current liabilities

An indicator of increasing operating cash flow is a sign of financial health. On the other hand, those companies with the decreasing indicator may have short-term liquidity problems.

Examples

Investment assets that take the longest to convert to cash may include preferred or restricted stocks. These types of stocks generally have agreements that dictate how and when they can be sold.

Coins, stamps, art, and other collectibles are less liquid than cash, if the investor wants the full value of the items.

For example, if an investor sold to another collector, they could get full value only by waiting for the right buyer. However, the item may be sold at a discount in value through a dealer or broker, if cash is urgently needed.

Land, real estate, or buildings are considered the least liquid assets, because it could take weeks or months to sell.

Asset purchase

Cash is considered the standard for financial liquidity, because it can be converted more quickly and easily into other assets. If a person wants a $ 1,000 refrigerator, cash is the asset most easily used to obtain it.

If that person does not have cash, but a collection of rare books that has been valued at $ 1,000, it is unlikely that you will find someone willing to trade their refrigerator for their collection.

Instead, you will have to sell the collection and use the cash to buy the refrigerator. That might be fine if the person can wait months or years to make the purchase. However, it could be a problem if the person was only a few days old.

You may have to sell the books at a discount, rather than waiting for a buyer who is willing to pay full value. Rare books are an example of an illiquid asset.

References

1. Jim Mueller (2018). Understanding financial liquidity. Investopedia. Taken from: investopedia.com.
2. Investopedia (2018). Liquidity. Taken from: investopedia.com.
3. Alex Burke (2018). The Definition of Liquidity in Finance. Small Business - Chron. Taken from: smallbusiness.chron.com.
4. The Economic Times (2018). Definition of 'Liquidity'. Taken from: economictimes.indiatimes.com.
5. Brett Romero (2017). The Advantages of Financial Liquidity. Taken from: blog.apruve.com.