accounting Accounting, also known as accountancy, is the measurement, processing, and communication of financial and non financial information about economic entities such as businesses and corporations. Accounting, which has been called the "languag ...

, 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 or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...

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 (from la, per centum, "by a hundred") is a number or ratio expressed as a fraction of 100. It is often denoted using the percent sign, "%", although the abbreviations "pct.", "pct" and sometimes "pc" are also use ...

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 In finance, the quick ratio, also known as the acid-test ratio is a type of liquidity ratio, which measures the ability of a company to use its ''near cash'' or quick assets to extinguish or retire its current liabilities immediately. It is defi ...

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 Operation or Operations may refer to: Arts, entertainment and media * ''Operation'' (game), a battery-operated board game that challenges dexterity * Operation (music), a term used in musical set theory * ''Operations'' (magazine), Multi-Man ...

can be calculated by dividing the

operating cash flow In financial accounting, operating cash flow (OCF), cash flow provided by operations, cash flow from operating activities (CFO) or free cash flow from operations (FCFO), refers to the amount of cash a company generates from the revenues it brings i ...

current liabilities In accounting, current liabilities are often understood as all liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer. A more complete definition is t ...

. This indicates the ability to service current debt from current income, rather than through asset sales.

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 of goods with the help of equipment, labor, machines, tools, and chemical or biological processing or formulation. It is the essence of secondary sector of the economy. The term may refer to ...

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 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 markets. Because ...

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 c ...

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. Fo ...

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 clients withdraw their money from a bank, because they believe the bank may cease to function in the near future. In other words, it is when, in a fractional-reserve banking system (where banks no ...

. 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.

References

Financial ratios Working capital management

Calculating liquidity

Understanding the ratios

Liquidity in banking

See also

References