(a) Explain what is meant by the liquidity of a company. Define two common accounting measures of liquidity.
(b) Why is liquidity an important indicator that an investor should consider when analysing share investment opportunities?
Answer: 7. a) A company must ensure that it has access to sufficient cash to be able to meet its current commitments and take future advantage of future business opportunities. This is indicated by the company’s level of liquidity, that means having ability to continue to meet its short-term financial obligations and thus to continue trading. Two common accounting measures of liquidity are:
i) Current ratio= Current assets (maturing within 1 year) /Current liabilities (due within 1 year) ii) Liquid ration= Current assets-Inventory (stock on hand)/ Current liabilities- Bank overdraft. 7. b) Liquidity is the ability of a company to meet the short term obligations. It is the ability of the company to convert its assets into cash. Short term, generally, signifies obligations which mature within one accounting year. Short term also reflects the operating cycle: buying, manufacturing, selling, and collecting. A company that cannot pay its creditors on time and continue not to honour its obligations to the suppliers of credit, services, and goods can be declared a sick company or bankrupt company.
Inability to meet the short term liabilities may affect the company’s operations and in many cases it may affect its reputation too. Lack of cash or liquid assets on hand may force a company to miss the incentives given by the suppliers of credit, services, and goods. Loss of such incentives may result in higher cost of goods which in turn affect the profitability of the business. Thus, liquidity is an important indicator that an investor should consider when analysing share investment opportunities to make sure that they are investing in the right company where they could get a good return on their investment.