© 2000 John Petroff

Liquidity is the ability of a company to transform immediately or on very short notice some of its assets into any other asset or into payment of an obligation. Cash is obviously the liquid assets par excellence. Fixed assets are illiquid, and capitalized organizational expenses are least liquid. In between, inventories and accounts receivables are called working capital and are usually lumped with cash to make up current assets as a company's short term source of liquidity. GAAP balance sheet assets are organized in decreasing degree of liquidity.

An operating firm has a large number of payments to make on a regular basis. These include payments to employees for their wages, suppliers of raw materials, providers of services, as well as various creditors such as banks. It is obvious that if the company does not have the necessary liquidity to make these payments, it may soon be out of business. Thus, analysis of liquidity is usually looked upon as an assessment of short term solvency. There is also a long run purpose of studying liquidity. If a firm lacks liquidity and barely meets its obligations, this may indicate that management lacks foresight and ability to plan, and its overall conduct of business can be seriously questioned.

Because of these two very serious problems, i.e. potential insolvency or gross mismanagement, analysis of liquidity must be the first step of most financial analyses. There is no point in looking at profitability or sales growth if the firm cannot pay its suppliers on time (except, naturally, if the purpose of the analysis is to study a firm that is known to be already in difficulty). The current ratio is commonly used for a quick check of liquidity, but to gain a deeper understanding of a company's ability to make payments several other approaches will be outlined in this chapter, as shown in the list of sections below.

A- Significance of liquidity
B- Cash cycle
C- Working Capital
D- Current ratio
E- Quick ratio
F- Cash and cash equivalents
G- Accounts receivable
H- Inventories
I- Current liabilities
J- Cash flows

Liquidity of a firm is measured by its cash balance plus marketable securities that can be quickly converted into cash, as well as other cash generating assets, such as accounts receivables and inventories. A company is not holding these assets solely for making specific payments, but for the purpose of generating sales, protecting itself from the unexpected or taking advantage of opportunities. Historical trends of all industries presented in Table T-8.6 show that firms have become less liquid over the past 40 years. The emphasis of liquidity analysis has shifted toward the ability to generate cash, for instance in studying cash flows, and away from the static and short sighted view of "what is in the till today". But, let us start with a more traditional discussion of liquidity.

See review questions Q-8.1 through 8.9.

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