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Definition
The term liquidity is used to describe the relative time it takes until an asset is converted into cash, or the payment of a liability is due. Liquidity is a comparative term, meaning it may be easier to convert one asset into cash than another.
Explanation
Different industries will have various degrees of liquidity. The challenge for the company's management team is to balance the need to invest in income-producing assets versus the near term need for cash to pay invoices for products and services as they come due. A shortage of liquidity can result in the inability to pay creditors and eventually lead to bankruptcy. Unfortunately, cash is not an income-producing asset; therefore, the company foregoes some opportunity to expand operations when holding cash.
Liquidity ratios allow analysts, investors, and creditors to quickly identify if a company may have trouble meeting its debt obligations coming due in the next twelve months. The most commonly used measures of liquidity include the cash, current, and quick ratios.
The cash ratio is the most rigorous test of a company's ability to satisfy short term debt. While the current ratio allows for all current assets in its calculation, the cash ratio limits the liquid assets to cash and marketable securities. Generally, a cash ratio value that approaches 1.0 is considered satisfactory. When drawing conclusions about the relative performance of a company, benchmark comparisons should be made with competitors in the same industry.
Related Terms
The financial accounting term current assets is generally defined as cash and other assets that can be converted into cash within one year or one operating cycle, whichever is longer. Current assets are a subcategory of assets, which appear on a company's balance sheet.
Moneyzine EditorNovember 6th, 2024
As it applies to the accounting discipline, cash includes paper money, coins, checks, money orders, and money on deposit with banks. In general, an item is classified as cash if a bank will accept it for deposit.Moneyzine EditorNovember 6th, 2024
The current ratio is a measure of liquidity. The calculation only requires two inputs from the balance sheet: current assets and current liabilities. The current ratio measures a company's ability to pay debt coming due in the next 12 months.Moneyzine EditorNovember 6th, 2024- Also known as the acid test, the quick ratio is a measure of liquidity, which is the ability of a company to pay its short term debt obligations using a subset of current assets known as quick assets. The calculation of the quick ratio requires information found on a company's balance sheet.Moneyzine EditorNovember 6th, 2024
The cash ratio is a measure of liquidity. The calculation only requires three inputs from the balance sheet: cash, marketable securities, and current liabilities. The cash ratio is one of several measures used by investors to understand a company's ability to pay debt coming due in the next 12 months.Moneyzine EditorNovember 6th, 2024
The accounting term financial flexibility is used to describe a company's ability to react to unexpected expenses and investment opportunities. Financial flexibility is usually assessed by examining the company's use of leverage as well as cash holdings.Moneyzine EditorJanuary 18th, 2024
The term liquidity risk typically refers to the inability of an investor to buy or sell an asset to minimize or avoid a financial loss. Liquidity risk can also refer to a company's inability to meet a debt obligation without incurring a loss.Moneyzine EditorNovember 6th, 2024
The term liquidity spread is used to describe the premium that flows to a party willing to provide liquidity to a party that is demanding it. Liquidity spreads apply to investments such as stocks and bonds, futures contracts, exchange-traded securities, options, commodities as well as other types of assets.Moneyzine EditorJanuary 23rd, 2024
