To keep a business running, it usually takes on a lot of financial obligations, including paying employees salaries and paying off loans and debts. To appease the various stakeholders, an organization must keep a healthy balance of liquid assets. People will be more likely to invest in, or lend to, a company that has enough liquidity to keep up its payments. However, a company can have too much liquidity, which may be a sign that it's holding onto cash that could be invested.
Examples of liquid assets for a corporation are similar to those of an individual:
- Funds in the bank
In a sense, even borrowing money is another typical source of liquidity for businesses. To meet its obligations, the ability to take out loans will be a factor in its liquidity.
Companies like to keep things in perspective to understand the big picture. For instance, they keep an eye on their net liquid assets, which is the amount of liquid they'd have if they paid off their current debts and liabilities using liquid assets. They also want to divide the situation into varying time frames. For instance, a company pays attention to the amount of quick assets, which are assets readily convertible to cash. It also calculates how much it has in current assets, which are all the assets it can sell within a year's time.
Using these concepts, businesses compare these factors in ratios to understand liquidity from different angles. For instance, here are two common ratios relating to liquidity:
- Current ratio: The figure you get when you divide current assets by current liabilities or debts due within a year.
- Quick ratio: Quick assets (which are sometimes calculated as current assets minus inventories) divided by current liabilities. Also called the acid test ratio. It is a measure of a company's more immediate financial situation.
This is where the idea of liquidity differs between personal finance and corporate finance -- a year's time is relatively long-term for an individual's financial obligations, but not for a company's. However, the idea of liquidity gets even more muddled in the corporate world. Whether an asset is liquid depends when the business's obligations are due. The time period for what makes a current asset, for instance, could be a year or the duration of the company's operating cycle. On the other hand, the company's willingness to sell off assets early (forcing itself to accept a discounted price) also plays into whether it can be counted as liquid.
A business also takes into account current market conditions when considering its own liquidity. In a liquid market, assets can consistently sell quickly and without a loss of value. On the other hand, during a thin market, the values of assets change rapidly, and selling assets at a profitable price becomes harder. Many factors influence how easy it will be -- such as inflation and interest rates. This can be understood in terms of the bid-offer spread, which is a comparison between the prices at which things are sold and later bought in a market. If the difference is slight, it makes for a reliable, liquid market. Conversely, if there's a big discrepancy, the market is thin. The foreign exchange, also known as Forex, is usually a reliable market for liquid assets [source: Investopedia].
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More Great Links
- "Liquid Asset." Investopedia.com. (July 22, 2008)http://www.investopedia.com/terms/l/liquidasset.asp
- Gentry, F. Bruce, et al. "The Compete Will Kit." John Wiley and Sons, 2001. (July 22, 2008)http://books.google.com/books?id=9zr8tKBfc9gC
- Loth, Richard. "Liquidity Measurement Ratios: Introduction." Investopedia.com. (July 22, 2008)http://www.investopedia.com/university/ratios/liquidity-measurement/default.asp
- McWhinney, Jim. "Build Yourself An Emergency Fund." Investopedia.com. (July 22, 2008) http://www.investopedia.com/articles/pf/05/EmergencyFund.asp