Answer 5 (a)

Liquidity is the ability of the firm to convert assets into cash. It is also called marketability or short-
term solvency. In other words, it is the ability of the firm to meet its day-to-day obligations.
In order to study the liquidity of the firm, we need to thoroughly examine its asset structure, mainly
the current assets. The current assets, viz stock, debtors, bank balance and other current assets need
to be seen to determine at what rate a firm can convert these into cash. ! business that collects its
accounts receivable in an average of "# days generally has more cash on hand than a business that
requires $% days. &imilarly, a business that turns over its inventory '% times a year has more cash on
hand than a com(any that turns its inventory only '# times a year. ! business which kee(s sur(lus
cash or an idle bank balance may be readily able to meet its short-term or daily obligations but it is
not effectively utilizing its cash flow.
!nother factor to determine the liquidity is to see the (rofitability of the firm. The more (rofitable
the firm is, the more cash resources it shall have.
Last, but not the least, we use make use of certain financial ratios like current ratio, quick or acid-test
ratio, net working ca(ital to determine the liquidity of the firm.
Answer 5(b)
The various (arties interested in determining the liquidity of the firm would be the business owners
and managers, bankers, investors, creditors and financial analysts.
)usiness owners and managers use ratios to chart a com(any*s (rogress, uncover trends and (oint to
(otential (roblem areas in a business. +ne can also use ratios to com(are your com(any*s
(erformance with others within the industry.
)ankers and investors look at a com(any*s ratios when they are trying to decide if they want to lend
you money or invest in your com(any.
,reditors are interested in the com(any-s short-term and long-term ability to (ay its debts.
.inancial analysts, who frequently s(ecialize in following certain industries, routinely assess the
(rofitability, liquidity, and solvency of com(anies in order to make recommendations about the
(urchase or sale of securities, such as stocks and bonds.
Answer 5(c)
The relevant ratios used to assess the liquidity of the firm are
current ratio, quick or acid / test ratio, cash ratio and net working ca(ital.
Current Ratio
0rovides an indication of the liquidity of the business by com(aring the amount of current assets to
current liabilities. ! business*s current assets generally consist of cash, marketable securities,
accounts receivable, and inventories. ,urrent liabilities include accounts (ayable, current maturities
of long-term debt, accrued income taxes, and other accrued ex(enses that are
due within one year. In general, businesses (refer to have at least one dollar of current assets for
every dollar of current liabilities. 1owever, the normal current ratio fluctuates from industry to
industry. ! current ratio significantly higher than the industry average could indicate the existence of
redundant assets. ,onversely, a current ratio significantly lower than the industry average could
indicate a lack of liquidity.
Formula
Current Assets
Current Liabilities
Acid Test or Quick Ratio
! measurement of the liquidity (osition of the business. The quick ratio com(ares the cash (lus cash
equivalents and accounts receivable to the current liabilities. The (rimary difference between the
current ratio and the quick ratio is the quick ratio does not include inventory and (re(aid ex(enses in
the calculation. ,onsequently, a business*s quick ratio will be lower than its current ratio. It is a
stringent test of liquidity.
Formula
Cash + Marketable Securities + Accounts Receivable
,urrent Liabilities
Cash Ratio
Indicates a conservative view of liquidity such as when a com(any has (ledged its receivables and its
inventory, or the analyst sus(ects severe liquidity (roblems with inventory and receivables.
Formula
Cash Equivalents + Marketable Securities
Current Liabilities
Working Capital
2orking ca(ital com(ares current assets to current liabilities, and serves as the liquid reserve
available to satisfy contingencies and uncertainties. ! high working ca(ital balance is mandated if
the entity is unable to borrow on short notice. The ratio indicates the short-term solvency of a
business and in determining if a firm can (ay its current liabilities when due.