5.5 Liquidity and Liquidity Ratios
Note:
Toward the end of chapter 5, the student will find a “Ratio Analysis Exercise.” As we go through and explain each of the twenty financial ratios below, the student will, one-by-one, calculate the ratios for the example given in the exercise. You will find that the example is constituted by a fictitious company’s Balance Sheet and Income Statement.
We are going to list 20 ratios – covering six categories– in this section. After this discussion, an exercise in calculating all the ratios is presented so that you may apply what you learned.
The first category is liquidity ratios. The idea of liquidity has to do with the ease and speed with which an asset may be converted into cash – without compromising its “true” worth or “intrinsic value.” It must satisfy both conditions in order to be considered liquid.
For instance, it is possible to sell virtually anything at a “fire–sale price,” if one needs the cash. The question is whether an item worth, say $100, will fetch $100 – or less. If less, we may say that the item is not liquid, as the seller did not obtain its true worth, even though s/he was able to obtain some cash for it.
An example of a liquid asset would be IBM stock. Let’s say it is trading for $190. Should one wish to sell 100 shares of the stock, s/he would obtain approximately $19,000 for it. However, if I wanted to sell my tie, for which I paid $50, it may be difficult for me to get that amount. Whether you wish to consider the asset’s “value” a matter of its original cost or its “current value,” is a matter of analytic choice and context.
The notion of liquidity is closely tied to another notion: “marketability.” This has to do with the availability of a market in which purchases and sales may be readily transacted. For instance, the stock market provides IBM common shares with a great deal of marketability. Should I however wish to sell my tie, I would not know where to go to find a “used-tie market.” Real estate markets are dominated by brokers who advertise frequently, and I may easily sell my car to a used car dealer.
In the case of your typical corporation, it will not own other companies’ stock. It will instead produce goods and services for sale and profit. Thus, it will regularly carry inventory and accounts receivable, which are reported as “current assets.” The net current assets (current assets less current liabilities), being short-term, are presumably liquid. If the assets are liquid, the firm will be able to quickly convert the assets into cash, which will be used to honor its current liabilities due. If not liquid, the firm will have difficulty paying its current liabilities; it will be said to have a “liquidity problem.”
Now that we know what is meant by liquidity and we understand that the liquidity notion applies to “net current assets,” let’s quantify the notion by detailing some relevant ratios that put numbers to the idea. The greater the measurable liquidity the less the risk