#note/reference

Liquidity

Liquidity is the ability to satisfy a company's short-term obligations using Assets that can be most readily converted into cash

Liquidity is important as it shows a firm's ability to meet its immediate obligations. They are more important to firms with differentiated products as these products are more difficult to sell quickly when cash is needed. Differentiated goods appeal to specific customer segments and selling them rapidly may require price reductions.

They can be measured by current and quick ratios.

Current Ratio

CR = Current Assets / Current Liabilities

This shows the firm's ability to cover current liabilities with current assets.

Inventory is typically the most difficult current asset to convert to cash, taking longer than accounts receivable to liquidate. This is because of a plethora of reasons

  1. AR represents completed sales awaiting payment of predetermined amounts, clear timelines and legal obligations. Inventory must first be sold before collecting payment, have no guarantee of sale at expected prices, a variable timeline and no pre-existing obligation.

Quick Ratio

Also known as the acid-test ratio.

QR = (CA - Inventory) / CL

The quick ratio is more conservative than the current ratio as it excludes inventory from CA, focusing only on the most liquid current assets (cash, AR).

Higher CR and lower QR indicates potential problems in inventories account, such as: