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Sunday, May 16, 2010

Short-term Solvency and Liquidity

Profitability is the amount of course an important aspect of a company’s performance and debt or gearing is another. Neither, however, addresses directly the key issue of liquidity.

Liquidity is the amount of cash a company can put its hands on quickly to settle its debts (and possibly to meet other unforeseen demands for cash payments too).

Liquid funds consist of:
  • Cash
  • Short-term investments for which there is a ready market
  • Fixed-term deposits with a bank or building society, for example, a six month high-interest deposit with a bank
  • Trade debtors (because they will pay what they owe within a reasonably short period of time)
  • Bills of exchange receivable (because like ordinary trade debtors, these represent amounts of cash due to be received within a relatively short period of time)

In summary, liquid assets are current asset items that will or could soon be converted into cash, and cash itself. Two common definitions of liquid assets are:

  • All current assets without exception
  • All current assets with the exception of stocks

A company can obtain liquid assets from sources other than sales, such as the issue of shares for cash, a new loan or the sale of fixed assets. But a company cannot rely on these at all times, and in general, obtaining liquid funds depends on marketing sales and profits. Even, so, profits do not always lead to increase in liquidity. This is mainly because funds generated from trading may be immediately invested in fixed assets or paid out as dividends.

The reason why a company needs liquid assets is so that it can meet its debts when they fall due. Payments are continually made for operating expenses and other costs, and so there is a cash cycle from trading activities of cash coming in from sales and cash going out for expenses.


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