Yesterday I came across an interesting article in Business Line, written by P.Saravanan and N.Sivasankaran. The article was about how can we calculate the liquidity of companies. A short description of that article is given below.
Accountants in fact size up companies on three main parameters- Profitability, Liquidity and Solvency measures. From this three things we can say that Liquidity and Profitability are inter related and inter connected.
Lets discuss the ways in which one can measure the liquidity position of a company.
UNDERSTANDING LIQUIDITY
Before going to calculate the liquidity, we first know what is meant by liquidity. We can define liquidity as the ability of a company to meet it's immediate obligations without any trouble or strain.
The obligations may consist of items such as accounts payable for the suppliers of raw materials, taxes payable, utilities payable and other expenses.
Normally how a company pay all these obligations...????? It is through CASH.
Where from an organisation gets the required cash for meeting all these obligations....???? It gets cash from the existing cash balance in hand, bank account balances and realization of cash by converting the current assets such as cash receivable, note receivable and inventories into cash.
WHAT IS THE IMPORTANCE OF THE ABOVE STATEMENT
From the above statement we can say that Liquidity contributes to Profitability. So what will happen if a company's liquidity position is poor...?? This means that the organisation is finding hard to meet it's payment obligations to outsiders such as suppliers of material.
If this situation continues, the suppliers will not supply the required materials for production. So the company can't achieve its marketing objectives.
TRADITIONAL MEASURES
There are mainly 2 traditional measures for measuring the liquidity of a company.
1) Current ratio
2) Liquidity or Quick Ratio (Acid-test ratio)
The current ratio is calculated by dividing the total of current assets by current liabilities. Here current assets can be of assets that are convertible into cash in one year or one operating cycle, which one is higher.
Similarly current liabilities are those obligations that are to be settled in one year or one operating cycle, which ever is longer.
A current ratio of 2:1 is considered to be good/satisfactory in theory. This indicate the company has Twice the amount of money invested in current assets than that of current liabilities.
The difference between current ratio and Quick ratio is that Quick ratio divides the Liquid assets by the current liabilities of a company.
Here Liquid assets include all the current assets except inventories and pre-paid expenses.
Regards Hari " लोका समस्ता सुखिनो भवन्तु "
Posts
