How effectively is your company able to pay its debts? What would happen if an emergency occurred, and you needed cash or cash equivalents to meet your short-term operating needs? Having a full understanding of liquidity in accounting is vital. Explore everything you need to know about the concept of liquidity with our simple guide. Firstly, let’s define liquidity in accounting.
Define liquidity in accounting
Liquidity, or accounting liquidity, is a term that refers to the ease with which you can convert an asset to cash, without affecting its market value. In other words, it’s a measure of the ability of debtors to pay their debts when they become due. So, what are liquid assets in accounting? Essentially, the easier it is to sell an investment for a fair price, the more “liquid” that investment is considered to be. Naturally, cash is the most liquid asset, whereas real estate and land are the least liquid asset, as they can take weeks, months, or even years to sell.
What is the order of liquidity in accounting?
It’s essential to understand the order of liquidity, i.e., the presentation of your assets on the balance sheet according to the amount of time it would take to convert them to cash. This gives you a better sense of how solvent your company would be in a crisis. For example, a company with very little cash but extensive real estate holdings might be in trouble. Here’s a rough guide to the order of liquidity, along with the amount of time necessary to convert each asset:
Cash – No conversion time necessary.
Marketable securities – In most cases, it would require several days to convert marketable securities into cash.
Accounts receivable – Accounts receivable liquidity depends on your company’s standard credit terms (usually 90 days, although in some cases, it may be substantially longer).
=Inventory – Depending on turnover levels, as well as the proportion of assets for which there isn’t a resale market, multiple months may be needed. In some cases, it won’t be possible to convert your inventory to cash without providing a substantial discount to willing buyers.
Fixed assets – Depends on whether there’s a market for the assets, but usually, fixed assets (i.e., land, real estate, machinery) require several months to sell.
Goodwill – Cannot be converted to cash until the sale of the company.
Understanding accounting liquidity ratios
To measure liquidity, you’ll need to master a couple of accounting liquidity ratios. The three most prevalent accounting liquidity ratios are as follows:
Quick ratio – Also known as the acid test ratio, the quick ratio measures your business’s ability to pay off your liabilities, with quick assets, i.e., current assets that can be converted to cash within 90 days. For example, cash equivalents, marketable securities, and accounts receivable are quick assets. The formula for the quick ratio is:
Quick Ratio = Cash + Cash Equivalents + Marketable Securities + Accounts Receivable
Current ratio – Arguably the simplest accounting liquidity ratio, the current ratio measures your company’s current assets against current liabilities. Unlike the quick ratio, which excludes items that you may not be able to liquidate quickly, you’ll need to include items like inventory and prepaid expenses in your calculations. The formula for the current ratio is:
Current Ratio = Current Assets / Current Liabilities
Cash ratio – As the most stringent accounting liquidity ratio, the cash ratio excludes inventories, accounts receivable, and other current assets, defining liquid assets solely as cash or cash equivalents. This means that it’s the best formula for assessing your company’s ability to stay solvent in an emergency. The formula for the cash ratio is:
Cash Ratio = (Cash + Cash Equivalents + Short-Term Investments) / Current Liabilities
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