Accounting terms

Dictionary of all accounting terms

What is Liquidity?

Liquidity describes the ease at which the asset can be bought or sold on the market without losing value.

Having cold, hard cash on hand is an asset in its most liquid form. Cash gives you or your business the ability to quickly and effectively purchase other essential assets.

If your business needs to acquire a new vehicle worth $15,000 with which to conduct deliveries, it will need to use cash or a loan to purchase said asset. An automobile salesman will not be able to accept your old printing press valued at $15,000 in exchange for a new vehicle your business needs. Now if there is no cash in your bank account, you will be forced to find another individual who would be willing to purchase your printing press for cash which will be then used for the vehicle purchase.

Let's assume you need to purchase the vehicle right away, so your printing press may have to be sold at a discount to help expedite the process. In theory, you could sell your printing press for the full amount of $15,000, but it may take some time - which you do not have. A person shows up to your door, and says "I will take the printing press right now for $10,000 in cash." You take the offer.

In essence, this means your asset - the printing press - is not liquid due to the fact it lost a sizeable amount of its value while it was being converted into quick cash.

Current Ratio

Current ratio is the simplest way to measure liquidity of your assets.

Current Ratio = current assets / current liabilities

Current asset in this case may be your inventory or anything else in your possession that can be reasonably converted into cash within one year.

Cash Ratio

Cash ratio is another way to measure liquidity of assets, excluding accounts receivable and current inventory.

Cash Ratio = (cash + short-term investments) / current liabilities

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