In
accounting
Accounting, also known as accountancy, is the process of recording and processing information about economic entity, economic entities, such as businesses and corporations. Accounting measures the results of an organization's economic activit ...
, liquidity (or accounting liquidity) is a measure of the ability of a
debtor
A debtor or debitor is a legal entity (legal person) that owes a debt to another entity. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor. When the counterpart of this ...
to pay their
debt
Debt is an obligation that requires one party, the debtor, to pay money Loan, borrowed or otherwise withheld from another party, the creditor. Debt may be owed by a sovereign state or country, local government, company, or an individual. Co ...
s as and when they
fall due. It is usually expressed as a
ratio
In mathematics, a ratio () shows how many times one number contains another. For example, if there are eight oranges and six lemons in a bowl of fruit, then the ratio of oranges to lemons is eight to six (that is, 8:6, which is equivalent to the ...
or a
percentage
In mathematics, a percentage () is a number or ratio expressed as a fraction (mathematics), fraction of 100. It is often Denotation, denoted using the ''percent sign'' (%), although the abbreviations ''pct.'', ''pct'', and sometimes ''pc'' are ...
of current
liabilities. Liquidity is the ability to pay short-term obligations.
Calculating liquidity
For a corporation with a published
balance sheet
In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business ...
there are various
ratios used to calculate a measure of liquidity. These include the following:
* The
current ratio is the simplest measure and calculated by dividing the total current assets by the total current liabilities. A value of over 100% is normal in a non-banking corporation. However, some current assets are more difficult to sell at full value in a hurry.
* The
quick ratio is calculated by deducting inventories and prepayments from current assets and then dividing by current liabilities, giving a measure of the ability to meet current liabilities from assets that can be readily sold. A better way for a trading corporation to meet liabilities is from cash flows, rather than through asset sales, so;
* The operating cash flow ratio can be calculated by dividing the
operating cash flow by
current liabilities
Current liabilities in accounting refer to the liabilities of a business that are expected to be settled in cash within one fiscal year or the firm's operating cycle, whichever is longer.Drake, P. P., ''Financial ratio analysis'', p. 3, publish ...
. This indicates the ability to service current debt from current income, rather than through asset sales.
* The
Crisis Liquidity Ratio (CLR), defined as (Current Assets – Receivables) / Current Liabilities, is used in crisis conditions to reflect situations where inventories may be more liquid than receivables. It was proposed by Bulgarian economist Petar P. Petrov and has been applied in liquidity studies of the Bulgarian automotive sector.
Understanding the ratios
For different industries and differing legal systems the use of differing ratios and results would be appropriate. For instance, in a country with a legal system that gives a slow or uncertain result a higher level of liquidity would be appropriate to cover the uncertainty related to the valuation of assets. A
manufacturer
Manufacturing is the creation or Production (economics), production of goods with the help of equipment, Work (human activity), labor, machines, tools, and chemical or biological processing or formulation. It is the essence of the
secondary se ...
with stable cash flows may find a lower quick ratio more appropriate than an Internet-based start-up corporation.
Liquidity in banking
Liquidity is a prime concern in a
banking
A bank is a financial institution that accepts Deposit account, deposits from the public and creates a demand deposit while simultaneously making loans. Lending activities can be directly performed by the bank or indirectly through capital m ...
environment and a shortage of liquidity has often been a trigger for bank failures. Holding
asset
In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that can b ...
s in a highly liquid form tends to reduce the
income
Income is the consumption and saving opportunity gained by an entity within a specified timeframe, which is generally expressed in monetary terms. Income is difficult to define conceptually and the definition may be different across fields. F ...
from that asset (cash, for example, is the most liquid asset of all but pays no interest) so banks will try to reduce liquid assets as far as possible. However, a bank without sufficient liquidity to meet the demands of their
depositors risks experiencing a
bank run
A bank run or run on the bank occurs when many Client (business), clients withdraw their money from a bank, because they believe Bank failure, the bank may fail in the near future. In other words, it is when, in a fractional-reserve banking sys ...
. The result is that most banks now try to
forecast their liquidity requirements and maintain emergency standby
credit
Credit (from Latin verb ''credit'', meaning "one believes") is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a debt) ...
lines at other banks.
Banking regulators also view liquidity as a major concern.
See also
*
Financial ratio
A financial ratio or accounting ratio states the relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall fin ...
*
Going concern
A going concern is an accounting term for a business that is assumed will meet its financial obligations when they become due. It functions without the threat of liquidation for the foreseeable future, which is usually regarded as at least the n ...
*
Liquidity (disambiguation)
*
Solvency
Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long- ...
References
{{Financial crises
Financial ratios
Working capital management