Liquidity definition – explanation and examples
The liquidity of a company simply explained
Everyone has certainly heard or said the phrase “I’m not liquid right now”. In technical jargon, this is referred to as liquidity. This is not only important in the private sphere, solvency plays an even more important role for companies. Thus, liquidity is also an important reference value for shareholders, traders and stockholders to be able to analyze a company. Various ratios are usually used for this purpose. What they are, how they are calculated and why too much liquidity is not good, we will cover in this article.
Liquidity Definition – What is it?
Liquidity indicates whether a company can meet its payment obligations. These obligations can be current costs such as salaries but also outstanding invoices. Liquidity here refers primarily to cash reserves or other holdings that can be quickly converted into cash. If the company is well positioned in this area, it is called a “solvent” (i.e. able to pay) company. The opposite would be insolvency.
A company’s cash and cash equivalents can be quickly identified on the balance sheet – they are found in current assets. These include, above all:
- Credit balances, for example at banks
The importance of liquidity
You know it from private life – if the running costs can no longer be paid, you have quite a problem. So it’s no surprise that this is also an important criterion in business life. Banks therefore examine a company thoroughly before granting a loan – after all, they live off the payment of interest. Prospective shareholders should also know how liquid a company is in order to avoid a rude awakening.
Of course, good liquidity comes about primarily from the fact that the company is generally doing well. A high turnover and the lowest possible costs are always two good characteristics for a solvent company. At the same time, a well thought-out company policy in the areas of profit distributions or capital increases is also necessary to ensure sufficient “liquid funds”.
Internally, solvency is usually ensured by means of so-called financial plans. These are intended to quickly identify and resolve potential difficulties. However, this can only be done on the basis of internal information that is not available to external investors. By means of ratios, however, they can still get an accurate picture of a company’s solvency. These are usually calculated on the basis of the balance sheets – the liquidity determined in this way therefore always reflects the past and not the current actual situation of the company.
Three degrees of liquidity
The liquidity of a company is calculated in three ways (also called degrees). Each degree includes other parameters in the calculation. Thus, in the end, one has a holistic picture of the financial situation of the company.
1. first-degree liquidity
First-degree liquidity is also called cash liquidity or cash ratio. The calculation is very simple – the above-mentioned cash and cash equivalents are set in relation to the current liabilities. Short-term liabilities are mainly debts with a maturity of up to one year. Since a percentage figure is to come out at the end, the result is multiplied by 100 percent at the end.
So the formula is as follows:
First-degree liquidity: cash and cash equivalents / current liabilities x 100 %.
At a value above 100 %, all current liabilities can be covered by cash and cash equivalents. In practice, however, first-degree liquidity is usually 20 or 30%. This is not a cause for concern, however, as other items on the balance sheet (receivables or inventories) can also be used to settle debts.
2. liquidity of the second degree
The second degree of liquidity is also known as the collection-related liquidity or quick ratio. The formula is similar to the one described above, but here the short-term receivables are added to the cash and cash equivalents. As with current liabilities, these receivables also have a maturity of approximately one year. The formula therefore looks as follows:
Second-degree liquidity: cash and cash equivalents + current receivables / current liabilities x 100 %.
This is used to check to what extent current receivables also contribute to liquidity. A good result here is in the range between 100 and 120%. A value below this can indicate various problems (for example, with product sales).
3. liquidity of the third degree
Third-degree liquidity also has two other names: sales-related liquidity or current ratio. Here, based on the second degree, inventories are added to cash and cash equivalents. As usual, the current liabilities are then divided by the newly calculated liquid assets. In practice, this looks like this:
Liquidity of the third degree:
Cash and cash equivalents + current receivables + inventories / current liabilities x 100%
A value of 120% is considered optimal here. A value below this can again indicate problems with the sale of the products. If the calculated figure is higher than 120, the company’s controllers must ask themselves whether there is too much in the warehouse and the capital is therefore tied up (pointlessly).
Liquidity too high or too low – the consequences
The consequences of too low liquidity are easy to foresee. Debts and obligations can no longer be serviced, which in the worst case leads to important assets or goods having to be sold. Then, however, it is also no longer possible to produce sufficiently, which in turn weakens profitability. This vicious circle can certainly understand even a layman in business administration.
But now what about having too much liquidity? What can be wrong with having a lot of money in the bank? Too much liquidity indicates, first and foremost, that there is money lying around “uselessly” in the company. Put another way: Equity investors expect a return on the capital they have invested.
But this can only happen by investing with the money. Thus, the money generates the return, so to speak. But if this is only in the company, the profitability suffers. Likewise, receivables and inventories should not be exorbitant. A golden mean is therefore also correct and important for liquidity.
Further key figures
A company can also measure its own liquidity with other ratios. These are briefly described below:
-> Dynamic liquidity ratio: This takes into account expected incoming and outgoing payments. These are in turn set in relation to current liabilities.
-> Working capital: This is the sum of inventories and receivables, from which current liabilities are deducted.
-> Working Capital Ratio: Here the complete current assets of the company are divided by the current liabilities.
Conclusion on liquidity
Alongside the equity ratio, liquidity is one of the most important ratios for determining the economic situation of a company. Investors should also look at the various ratios in any case before they buy the shares of a company. Although the figures are very easy to find in the balance sheet, they can only ever reflect the past. Nevertheless, this should be sufficient for most companies. The good thing about it is that liquidity is not only important, it is also very easy to calculate. Have fun analyzing the companies.