Term
Liquidity
What is liquidity in a company?
Answer
Definition
Liquidity is a company’s ability to meet its short-term financial obligations as they fall due without raising external finance.
The Acid Test Ratio provides a stricter test of short-term financial health.
Strategic moves to manage working capital and enhance short-term cash availability.
Conclusion: Understanding and managing liquidity ratios help prevent cash flow crises and support business sustainability.
What is liquidity in a company?
Liquidity is a company’s ability to meet its short-term financial obligations as they fall due without raising external finance.
Why is liquidity important for a business?
It ensures smooth operations, timely payments to suppliers, workers, and creditors, and helps avoid insolvency.
How is the current ratio calculated?
Current Ratio = Current Assets ÷ Current Liabilities.
What does a current ratio above 1 signify?
It indicates the company can meet its short-term debts.
What is considered a healthy current ratio?
Typically between 1.5 and 2, though it varies by industry.
How is the acid test ratio (quick ratio) calculated?
Acid Test Ratio = (Current Assets – Inventory) ÷ Current Liabilities.
Why exclude inventory in the acid test ratio?
Inventory is less liquid and may not be easily converted to cash quickly.
What does an acid test ratio above 1 indicate?
Strong liquidity excluding inventory, meaning the company can cover short-term debts with more liquid assets.
Name one method to improve liquidity.
Speeding up collection of receivables.
How can reducing inventory improve liquidity?
It frees up cash tied in stock, increasing liquid assets available to pay liabilities.