Liquidity is the ability to convert assets into cash. Liquidity analysis is widely used by banks and other financial institutions to assess a business entity's ability to repay debt. Liquidity analysis measures can be categorized by current position analysis, accounts receivable analysis, inventory analysis, and accounts payable analysis.
Liquidity is commonly examined by evaluating ratios, including working capital, current ratio, quick ratio, accounts receivable turnover, average collection period, inventory turnover, days sales in inventory, accounts payable turnover, and days payable outstanding. Ratios are a way to analyze organizational performance using information found in the income statement, balance sheet, and statement of cash flows.
Current Position Analysis
Current position analysis examines the current financial state of a business. It captures information that helps assess the short-term financial health of the company and its ability to manage cash flow. Formulas commonly used in current position analysis include working capital, current ratio, and quick ratio.Used to gauge current financial position, working capital is a tool that measures a business entity's ability to pay current liabilities. Working capital is calculated by deducting current liabilities from current assets. It can be assessed monthly, quarterly, or annually. To illustrate, a company called Charlie's Camper Company has current assets of $525,000 and current liabilities of $210,000. The company’s working capital is $315,000. This means it has $315,000 of current funds left after considering all current liabilities.
Accounts Receivable Analysis
Accounts receivable, for many organizations, are a significant asset in the current asset section of the balance sheet. Ability to manage credit terms and collections with customers is crucial to keeping accounts receivable accounts up to date and in keeping the organization’s cash flow healthy. Thus, measuring and assessing accounts receivable is important, and also reflects liquidity. Accounts receivable analysis ratios assess the ability of an entity to collect its accounts receivable. Accounts receivable turnover measures how often accounts receivable are converted into cash, on average, within a year. The accounts receivable turnover ratio can be computed by dividing sales (not cash sales) by the average accounts receivable.To illustrate, assume Charlie's Camper Company has annual sales of $1,000,000 and average accounts receivable of $275,000. The accounts receivable turnover is 3.64, which means that, on average, accounts receivable is collected 3.64 times per year.
Defined as the ability of a business entity to manage its inventory, inventory analysis uses two ratios to accomplish its goal: inventory turnover and number of days sales in inventory. As an efficiency measure, inventory turnover measures the number of times a business entity sells and replaces its inventory, on average, within a year. It can be computed by dividing cost of goods sold by the average inventories. A high inventory turnover ratio may indicate efficient inventory management, while a low inventory turnover ratio may indicate poor inventory management. However, certain businesses, such as those that sell luxury goods, may typically have low inventory turnover.For example, Charlie's Camper Company has a cost of goods sold of $600,000 and average inventory of $125,000. Its inventory turnover is 4.8, which means that the company is using and replacing its inventory, on average, 4.8 times per year.