Liquidity Explained

The term liquidity typically applies to the ease with which a given asset that belongs to a company can be converted into cash without affecting its market price. Liquidity also refers to a business’s ability to pay all its bills, debt and other liabilities within a given timeframe.

Liquid assets include cash, cheques, portfolio lines of credit, publicly traded securities like stocks, shares and bonds as well as accounts receivable.

The importance of liquidity for a limited company

Liquidity is an important metric for financial health. Good liquidity is appealing to an investor, bank or potential shareholder as it demonstrates that the company is well-equipped to handle future financial challenges and mitigate risk. Liquidity means being able to pay a deposit on a new business premises, make an investment in equipment or personnel, and pay down debts in a timely manner.

Liquidity ratios

A liquidity ratio measures the ratio of assets against liabilities on the company balance sheet. There are 3 types of liquidity ratios.

Current ratio

The current ratio measures current company assets against its current liabilities. These are monies owed within 12 months.

The ratio is as follows:

Current assets ÷ Current liabilities = Current liquidity

Quick ratio

A company’s quick ratio is an ultra-short-term version of the current ratio. It measures cash equivalents (assets that can be sold within 3 months for a set cash value) and accounts receivable within the next 3 months against current liabilities within the next 3 months. A quick ratio is a great way to measure liquidity for the immediate future.

The ratio is as follows:

Accounts receivable + Cash equivalents = Quick liquidity

Cash ratio

The cash ratio measures its most liquid assets against current liabilities. And assets don’t get more liquid than cash. Cash equivalents are also included as they are relatively quick and easy to liquidate.

The ratio is as follows:

Cash + Cash equivalents ÷ Current liabilities = Cash liquidity

Liquidity vs Cash flow: What’s the difference?

Because both liquidity and cash flow involve the tracking of liquid assets to assess a company’s spending power, they are often used interchangeably. However, while cash flow refers to the general availability of cash, liquidity refers to a company’s ability to meet immediate financial obligations.

The liquidation process

When a company becomes insolvent and cannot meet its financial obligations it will go into liquidation. This is to a company what being made bankrupt is to an individual debtor. Company liquidation may be voluntary or compulsory. Voluntary liquidation is where company directors are content to liquidate the company’s assets (including non-liquid assets like equipment, machinery, plant and property) to satisfy the company’s creditors. Compulsory liquidation, on the other hand, is where one or more creditors petition the court to liquidate company assets to repay debts and satisfy the creditors.

In both cases, a liquidator is appointed to help wind up company operations and realise the company’s assets – disposing of them at the best possible market price.

Liquidity FAQs

What is liquidity risk?

Liquidity risk can refer to either:

• The risk of a company having insufficient liquidity to cover its current liability or

• The risk that a financial asset cannot sell quickly enough to be deemed liquid without affecting its market value

Is liquidity the same thing as working capital?

Working capital is similar to liquidity in that they both analyse preparedness for upcoming expenses. However, liquidity refers to the financial capacity to cover those costs, while working capital refers to how much is left after those costs are incurred.

Why is liquidity important for businesses?

Liquidity is important as it shows prospective investors that the company meets its financial responsibilities and remains solvent. Companies with healthy liquidity also tend to have good cash flow to fund growth without the need to rely on a loan or credit. In times of high volatility, it can also be an encouraging sign for your clientele and employees.