Liquidity Measures The Financial Situation Of Business

1. Liquidity ratios are a class of financial metrics that is used to determine a company's ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts.

Liquidity ratios measure the business ability to pay all its short-term debts, it can be divided into current ratio and the acid test ratios. Current ratio examines the liquidity position of a firm, an ideal current ratio would be 1.5 : 1. The Acid Test Ratio provides us a tighter measure of a firm’s liquidity, by comparing current assets and liabilities after omitting stock from the total current assets. The ideal result for this ratio should be 1:1. These two ratios focus on the business financial stability on the short term only.

Current ratio is type of liquidity ratio. It is a financial tool used to measure a company’s ability to pay off its short-term debts with its short-term assets. A company’s current ratio is expressed by dividing its current assets by its current liabilities. A higher current ratio means the company is more capable of paying off its debts. If the current ratio is under one, this suggests the company is unable to pay off its obligations if they were due at that point (Investopedia, 2013). Companies that have trouble collecting money for its receivables or have long inventory turnovers can run into liquidity problems because they are unable to lessen their obligations.

“The short-term liquidity ratios are used in the evaluation of short-term liquidity to convert current assets into cash in order to reduce the financial obligations of the company as they become due” (Covee 2010 pg.45). These ratios are particularly significant to the creditors and potential lenders of a company because they determine the ability of that company to meet current payments of a debt.

One determinant of a company’s debt capacity is the liquidity of its assets. An asset is liquid if it can be readily converted to cash, while a liability is liquid if it must be repaid in the near future. Liquidity is the company’s working capital, current ration and acid-test ration. The components of Liquidity are Working Capital, Current Ratio and Acid Test Ratio.

The relationship of current assets to current liabilities is an important indicator of the degree to which a firm is liquid (Woelfel, 1994).

Liquidity risk is the risk that the Company will encounter difficulty in meeting the obligations associated with its financial liabilities that are settled by delivering cash or another financial asset. The Company’s approach to managing liquidity is to ensure, as far as possible, that it will always have sufficient liquidity to meet its liabilities when due, under both normal and stressed conditions, without incurring unacceptable losses or risking damage to the Company’s reputation.

Liquidity refers to the ability to have sufficient cash (from current assets) to pay current liabilities when they fall due (Titan, 2012, p. 208). Inversely, if a company has a low liquidity rate, i.e. higher liabilities than assets, it can be concluded that the company will have difficulty financing its running operations, as well as its current obligations.

Liquidity ratios measure a company’s capability in achieving their short-term financial debts, for example current assets ratio and quick ratio. (Campbell R.Harvey, 2004b)

Liquidity ratios shows the ability of a company to pay off short term obligated debts and fulfill the requirements of cash for unexpected events [1]. The comparison of the liquidity ratios of several individual companies is meaningful, only if those companies are in a same industry and legal system. In the rest of this part, we are going to discuss more details about working capital and current ratio which are 2 key indicators for displaying the liquidity of companies

As the creditors’ view, they prefer the high current ratio. The current ratio provides the best single indicator of the extent, which assets that are expected to be converted to cash fairly quickly cover the claims of short-term creditors. However, consider the current ratio from the perspective of a shareholder. A high current ratio could mean that the company has a lot of money tied up in nonproductive assets.

In order to be able to cover liabilities company must convert its assets into cash in short term. The Liquidity of any firm can be measured by calculating current ratio, quick ratio and working capital. In 2011 Inditex had liquidity ratio of 1.9 while its rivals such as H&M and Gap has 2.7,1.9 respectively ( Table2). In addition, in 2012 the liquidity ratio of inditex increased to 2.01 which is good. Nevertheless, the Working Capital Ratio of Inditex is quite low as it was scored 0.25. This can be a threat for Inditex as it could face difficulties in the future to cover its current liabilities because of the low Working Capital which is not enough to cover current liabilities. As a result, company would not be able to meet its expectations in affording growth and expansion of its inventory.

Liquidity of a company is a company’s ability to measure the extent to which a business can convert assets or has cash availability in order to meet the short-term liabilities and immediate obligations. Without this a company can fail very quickly.

In present era, liquidity and profitability trade off has become very important issue in any organisation. If the firm decreases its liquidity, the profitability of the firm would be high. So the result shows that there is a negative relationship between profitability and liquidity of the firm. So in other words we can say that there is essential to maintain the balance between liquidity and profitability of the

Liquidity Ratios help us analyze the firm’s ability to meet its short term financial obligations that’s why they are also called short term solvency ratios.