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About: Liquidity     Goto   Sponge   NotDistinct   Permalink

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As we saw previously, liquidity is the capacity of a business to find the resources needed to meet its obligations in the short-term. For such reason, the liquidity on the Balance Sheet is measured by the presence of Current Assets in excess of Current Liabilities or the relationship between current assets and current liabilities. Why do we need to assess the liquidity of a business? For several reasons; Imagine, you are establishing a contact with a new supplier. There is not precedent history between you two. The supplier wants some sort of guarantee that you will be able to meet the future obligations. Therefore, he asks for a credit report about your organization. This report shows whether an organization has enough liquidity to sustain its operations in the short-term. How? Based on the main liquidity ratios of your organization a rating will be assigned. The rating is a grade the organization gets if it meets certain criteria. Based on that rating the supplier will decide whether to entertain business with you or not. Of course, the Rating itself is more qualitative and quantitative. In other words, the numbers provided by the liquidity ratios will be intersected with other metrics (such as profitability ratios and leverage ratios). Another example, imagine you want to open an overdraft account with a local bank. The same scenario applies, since the local bank will assess your credit score before approving the overdraft. Thereby, the bank will look at your BS and see how liquid the organization is. What are the main liquidity ratios? Current Ratio = Current Assets/Current Liabilities Quick Ratio = Liquid Assets/Current Liabilities Absolute Ratio = Absolute Assets/Current Liabilities