Liquidity - What does liquidity mean? Read more here

Learn all about liquidity in accounting and eCommerce. Get an introduction, understand its use and see practical examples of calculating liquidity

Understand the importance of liquidity: How to ensure your business is financially sound and avoid payment problems

What is liquidity?

Liquidity refers to how quickly and easily a business can convert its assets into cash without losing value. It is a crucial factor for any company as it directly impacts the company's ability to pay its bills, wages, and other obligations on time. In short, liquidity is a measure of a company’s financial health and its ability to maintain stable operations.

How is liquidity used in accounting?

In accounting, liquidity is used to assess a company's short-term ability to pay its obligations. There are several ways to measure liquidity, but the most common ones are:

  • Current Ratio: This ratio is calculated by dividing a company’s current assets by its current liabilities. It shows how many times the company can cover its short-term obligations with its current assets.
  • Quick Ratio: This is a stricter test of liquidity as it only considers the most liquid assets (cash, securities, and receivables), excluding inventory.
  • Cash Ratio: This measurement focuses only on the company’s cash and cash equivalents in relation to its short-term liabilities.

Practical example of liquidity Calculation

To illustrate how liquidity is calculated, let’s take a concrete example. Assume we have a company with the following balance sheet items:

  • Cash: 50,000 DKK
  • Receivables: 30,000 DKK
  • Inventory: 20,000 DKK
  • Current liabilities: 60,000 DKK

Current ratio

Calculated as:

Current Ratio = Current Assets / Current Liabilities

The company’s current assets are the sum of cash, receivables, and inventory:

Current Assets = 50,000 DKK + 30,000 DKK + 20,000 DKK = 100,000 DKK

So:

Current Ratio = 100,000 DKK / 60,000 DKK = 1.67

This means the company has 1.67 DKK in current assets for every 1 DKK in current liabilities, which is generally considered a healthy liquidity ratio.

Quick Ratio

Calculated as:

Quick Ratio = (Cash + Receivables) / Current Liabilities

Current assets excluding inventory:

Quick Assets = 50,000 DKK + 30,000 DKK = 80,000 DKK

So:

Quick Ratio = 80,000 DKK / 60,000 DKK = 1.33

This shows that the company is still in a solid position, even without including inventory in its most liquid assets.

Cash Ratio

Calculated as:

Cash Ratio = Cash / Current Liabilities

Cash = 50,000 DKK

So:

Cash Ratio = 50,000 DKK / 60,000 DKK = 0.83

This means the company has 0.83 DKK in cash for every 1 DKK in current liabilities, which is still reasonable but shows the company is slightly less liquid without other quickly convertible assets.

Learn all about liquidity in accounting and eCommerce. Get an introduction, understand its use and see practical examples of calculating liquidity