Liquidity in Accounting Explained for Dummies

What is accounting liquidity?

Accounting liquidity, also referred to as financial liquidity, refers to the liquid assets owned by a person or a business that can easily be converted into cash to cover short-term debt.

Accounting liquidity is to be discerned from market liquidity.[1]

Accounting liquidity is basically about the ability of an individual or business, such as a company, to have enough liquid assets available to meet short-term financial obligations, paying off debts as they come due.

What are liquid assets?

Liquid assets refer to cash available and assets that can easily and quickly be converted to cash.

Other than cash, which is the most liquid asset, liquid assets comprise assets such as:

• Cash equivalents, the second most liquid of assets considered liquid, are investments that can easily be converted to cash. Typically, in less than 90 days.

Examples of cash equivalents are, amongst others, bank accounts, marketable securities (such as ordinary shares, treasury bills, money market instruments), and short-term government bonds.

Cash equivalents do not lose their value when they are traded.

• Inventories include items like finished goods and raw materials.

• Accounts receivable, commonly called receivables, refer to money owed to a business by customers who purchased goods on credit.

The scale of the liquidity of inventories and receivables can vary from business to business, depending on the type of business. For many companies, receivables are more liquid than inventories, implying that money owed by debtors is collected faster than selling goods in inventory.

Requirements for an asset to be regarded as liquid are, inter alia:

• It must be traded in a well-established market and must be generally recognised and accepted.
• The market in which the asset is traded must consist of a large number of interested buyers and sellers.
• It must possess the ability for ownership to be transferred quickly between traders.

Contrary to liquid assets, non-liquid assets cannot readily be converted into cash. Examples of non-liquid assets, also known as illiquid assets, are property, plant, and equipment (PP&E) and vehicles, to name a few.

As mentioned, liquid assets are crucial for a business to fulfil its short-term debt obligations.

Short-term debt also referred to as current liabilities, refers to the financial obligations of a business that are required to be paid off within a year. Short-term debt comprises, amongst other types of debt, accounts payable, taxes payable, short-term loans, and lease payments.

The reporting of liquid assets on the balance sheet of a business

Liquid assets are reported as current assets on the balance sheet of a company.

Typically, assets are listed from the most to the least liquid on a balance sheet. Hence, current assets, encompassing liquid assets, are listed before other types of assets like long-term assets (fixed assets), such as property, machinery, and vehicles.

As the most liquid asset, cash is always listed at the top of the current assets section.

If a company has intangible assets such as patents or trademarks, they are listed after fixed assets.

Measuring liquidity in accounting

In accounting, various liquidity ratios[2] are available to determine the liquidity of a business.

As a general rule, when applying liquidity ratios, a ratio greater than one is preferable.

Liquidity ratios are useful and important financial tools in accounting, enabling:

• creditors, such as suppliers, to determine if a business can cover its short-term debt obligations,
• lenders to decide whether they should extend credit to a business, and
• investors to analyse a company’s ‘investment worthiness’, determining whether a company is financially healthy.  

Liquidity ratios encompass the following ratios, namely the current ratio, the quick ratio, the cash ratio, and the operating cash flow ratio.

Current ratio

The current ratio is used for measuring the ability of a business to settle its short-term liabilities (short-term debt) with its current assets.

The current ratio can also be referred to as the working capital ratio.

Quick ratio

The quick ratio also determines whether a business has the capability to pay off its current (short-term) liabilities with its current assets. However, it applies a stricter test to calculate the ratio than the current ratio because it excludes less liquid current assets such as inventory and prepaid expenses.

Cash ratio

The cash ratio is also called the cash asset ratio because it determines whether a business can honour its short-term debt by only including the cash and cash equivalents in the calculation.

Hence, the cash ratio is the most conservative and strictest ratio of the current ratio, the quick ratio, and the cash ratio.

Operating cash flow ratio

The operating cash flow (OCF) ratio measures how effectively a business will be able to pay off its current liabilities with the money received from its normal business operations.

Put differently, the operating cash flow ratio calculates how easily the current liabilities of a business are covered by the cash flows generated from its operating activities during a specific accounting period.

The cash flow from operations (operating activities) is obtained from the business’s statement of cash flows.

The importance of accounting liquidity

Generally, there are numerous reasons that can cause the failure of a business, one of them being a liquidity crisis.

Financial analysts and accountants often mention a liquidity crisis can be harmful to an otherwise solvent business. As a matter of fact, a serious liquidity problem can be more detrimental to the survival of a business than a shortfall in the budget.

A business may have enough assets as a whole to eventually meet all its financial obligations, but it does not have enough liquid assets to honour its short-term obligations, such as salaries and wages of employees, short-term loans, and operational bills, as they come due.

Such a dire situation could eventually lead to liquidation and bankruptcy, as employees, lenders, and creditors demand payment.

Hence, a sound liquidity management strategy is crucially important for the well-being and survival of a business, enabling the business to beat financial challenges, secure loans from lenders, cover all expenses, and maintain financial stability.

[1] Refer the article, ‘Market Liquidity Explained for Dummies’, for a detailed explanation of market liquidity.

[2] See the article, ‘Liquidity ratios in Accounting Explained for Dummies’, for formulas and examples of liquidity ratios.