FollowThe strict definition of liquidity is the flow or fluid quality of a substance. Inherent in this definition is also the characteristic of a smooth, even, steady flow. In accounting, the term is best understood as an analogy. It is a word used to describe the overall financial condition of a business. For a business to be financially healthy, its finances must possess the free-flowing, consistent quality of a liquid.
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In Business
For businesses, this refers to the ability of that business to meet the financial obligations it has made, inherited or otherwise incurred. Generally, this term is used as a reference to immediate, day-to-day expenses running a business requires. It may or not reflect the overall value or worth of that business.
Examples
Anything the company owns that can be sold in exchange for cash is part and parcel of that company’s liquid profile. Equipment, vehicles, even stocks which can be immediately sold for cash, should a financial disaster strike, are considered in assigning a company its total, financial health assessment.
Financial Importance
How well a company manages its finances is directly reflective of that company’s staying power. Staying power is a critical metric. It is one of the cornerstones for how banks and lending institutions make lending decisions to any company.
Financial strength dictates first whether to extend and approve the loan. It is also a determining factor of how much a company can borrow. In turn, the borrowing ability of a business is equally a measure of its perceived financial strength.
Ratio
This is a measurement number for judging a company’s financial ability to pay its immediate and short term outstanding financial obligations when and as they are scheduled and without the need to rely on other means of raising that required capital. The formula for calculating the current ratio is a simple equation: Current Ratio = Current Assets/Current Liabilities. That is, total assets divided by total liabilities. Quick Ratio and Days Outstanding are other pertinent formulas for determining financial strength more specifically. Business Plan Hut This site has additional examples of ratio calculations for you to review.
Balance Sheet Order
To the accountant, where these figures appear and their order of appearance is telling. They are entered on the balance sheet in the order of conversion time required for each. This standard dictates that cash on hand is always the first listed. Stocks and bonds or other readily marketable securities are listed next. Accounts receivable, inventory and fixed assets make up the preponderance of the other balance sheet items. These complete the asset list that comprises any business financial standing summary.
High or Low Ratio
High asset worth or ratio is generally thought of as preferable to low asset worth. Banks and investors tend to view such companies as strong-performing companies. Both seek out companies with the most favorable ratios.
Companies with low ratios reflect to the lender or investor that available money is pretty much consumed in assets which are not liquid or quickly converted.
This indicates a lower margin of quickly recoverable money is available for financial emergencies. This is understandably a potential red flag for those appraising potential investment or evaluating a loan request.
Summary
A company’s financial state is directly reflected on its balance sheet. Whether that company remains a healthy, growing company can generally be predicted by its numbers. Business is a numbers-reliant endeavor, and no other factor is a stronger indicator than liquidity.
