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LIQUIDITY
In accounting, liquidity (or accounting liquidity) is a measure of the ability of a
debtor to pay their debts as and when they fall due. It is usually expressed as a ratio
or a percentage of current liabilities. Liquidity is the ability to pay short-term
obligations.
At the stock level: Liquidity refers to how easy it is to buy or sell a large number of
shares without having a big effect on share price.
At the company level: Check the liquidity of your companies to see if they would
be able to access cash quickly if necessary, for instance, to make a debt payment.
Are there enough cash and "cash equivalents" on hand to cover the payment?
At the market level: Markets and economies in general need to have liquidity, in
terms of a flow of money and credit, otherwise operations are hindered, as there's
no fuel, no grease.
LIQUIDITY MANAGEMENT
The importance of liquidity management is reflected in the fact that financial
managers spend a great deal of time in managing current assets and current
liabilities. The key issues in liquidity management are as to how much must be
invested in each component of liquidity management and how to manage these
components effectively and efficiently.
Proper management of liquidity is very important for the success of an enterprise.
The manner of management of liquidity to a very large extent determines the
success of the operation of concern.
The failure of any enterprise is undoubtedly due to poor management and absence
of management skill. Shortage of liquidity, so often advance as the main cause of
failure is nothing but the clearest evidence of poor management, which is so
common.
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LIQUIDITY RATIOS
Liquidity Ratios are also termed as Short-Term Solvency Ratios. The term liquidity
means the extent of quick convertibility of assets in to money for paying obligation
of short-term nature.
Accordingly, liquidity ratios are useful in obtaining an indication of a firm's ability
to meet its current liabilities, but it does not reveal how effectively the cash
resources can be managed.
The days' sales in accounts receivable ratio, also known as the number of days of
receivables, tells us the average number of days it takes to collect an account
receivable. Since the days' sales in accounts receivable is an average, you need to
be careful when using it.
Due to the high importance of cash in running a business, it is in a company's best
interest to collect outstanding receivables as quickly as possible. By quickly
turning sales into cash, a company has the chance to put the cash to use again ideally, to reinvest and make more sales.
The Accounts Receivable Turnover Ratio measures the number of time accounts
receivable turned over during a time period. A higher ratio indicates a shorter time
between making a sale and collecting the cash.
The ratio is based on Net Sales and Net Accounts Receivable. Remember, Net
Sales equals Sales less any allowances for returns or discounts. Net Accounts
Receivable equals Accounts Receivable less any adjustments for bad debts.
of it as the number of days of sales that was held in inventory during the specified
year.
INVENTORY TURNOVER
INVENTORY TURNOVER =COST OF GOODS SOLD/AVERAGE
INVENTORY
The Inventory Turnover Ratio measures the number of times inventory turned
over or was converted to sales during a time period. It may also be called the Cost
of Sales to Inventory Ratio. It is a good indication of purchasing and production
efficiency.
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In general, the higher the ratio, the more frequently the inventory turned over. You
might expect a company with a perishable inventory, such as a grocery store, to
have a very high Inventory Turnover Ratio.
Conversely, a furniture store might have a low Inventory Turnover Ratio.
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Once you have calculated the Inventory Turnover Ratio, you can convert it to the
actual number of days of inventory you have on hand. This key ratio combined
with the Accounts Receivable Days on Hand and Accounts Payable Days convert
to what is called the Cash Cycle.
OPERATING CYCLE
OPERATING CYCLE =ACCOUNTS RECEIVABLES TURNOVER IN
DAYS +
INVENTORYTURNOVER IN DAYS
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The cash conversion cycle (CCC, or Operating Cycle) is the length of time
between a firm's purchase of inventory and the receipt of cash from accounts
receivable. It is the time required for a business to turn purchases into cash receipts
from customers.
Operating Cycle represents the number of days a firm's cash remains tied up within
the operations of the business. A cash flow analysis using operating cycle also
reveals in, an overall manner, how efficiently the company is managing its working
capital.
WORKING CAPITAL
WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES
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CURRENT RATIO
CURRENT RATIO = CURRENT ASSETS / CURRENT LIABILITIES
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A high current ratio may mean cash is not being utilized in an optimal way. For
example, the excess
cash might be better invested in equipment.
The quick ratio is also called the acid test ratio. Thats because the quick ratio
looks only at a companys most liquid assets and compares them to current
liabilities. The quick ratio tests whether a business can meet its obligations even if
adverse conditions occur.
In general, quick ratios between 0.5 and 1 are considered satisfactory, as long as
the collection of receivables is not expected to slow.
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CASH RATIO
CASH RATIO = CASH EQUIVALENTS + MARKETABLE SECURITIES
/CURRENT LIABILITIES
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The relationship between Net Sales and Working Capital is a measurement of the
efficiency in the way working capital is being used by the business. It shows how
working capital is supporting sales.
In general, a low ratio may indicate an inefficient use of working capital; that is,
you could be doing more with your resources, such as investing in equipment.
A high ratio can be dangerous, since a drop in sales, which causes a serious cash
shortage, could leave your company vulnerable to creditors.
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