Principles of Accounting: Introduction to Liquidity Ratios

• Liquidity is a measure of how well a business can meet its short term obligations as and when they fall due
• It is usually expressed in terms of how well the entity/business in question can convert its assets into cash
• Short term obligations include amounts owed to creditors, bank overdraft, interest on debentures
• Short term obligations are also known as current liabilities
• These are amounts owing that have to be settled by the business within a period of one year or less
• In accounting and finance liquidity is usually measured by how well current assets can meet current liabilities
• Current assets comprise cash and other items that can be quickly converted into cash to pay creditors when they come calling
• Liquidity ratios are therefore used to express the level of risk that a business will be able or not able to pay its creditors when they demand payment
• At this level you are required to be familiar with the following liquidity ratios:
  1. Current Asset Ratio
  2. Acid Test Ratio/Quick Asset Ratio
  3. Rate of stock turn now called Rate of Inventory Turnover
• Liquidity is an important measure as it is quite possible for a business to fail even when it is making a profit
• This is because if a business fails to settle its liabilities it might be forced to liquidate
• It assets are then sold in order to pay its liabilities
• Normally the data/information used to calculate liquidity ratios is readily available in the Statement of Financial Position/Balance Sheet

To access more topics go to the Principles of Accounting Notes.