How to calculate liquidity and short-term liquidity

Net current assets in the balance sheet represents liquidity. They show how well a business will be able to trade within its own resources going forward

What is Liquidity

Net current assets describe working capital, which in turn broadly describes liquidity. It is the most important component of the balance sheet as it indicates cash flow solvency arising exclusively from core trading assets and resources.

Working Capital represents cash and cash convertible current assets that can be reasonably expected to be turned into cash within twelve months, less current liabilities, payable within twelve months.

It is usually measured by the current ratio, simply current assets divided by current liabilities.

Positive Liquidity

Negative net current assets describe a liquidity deficit. A business plan forecasting such as deficit should be avoided at all costs as banks deal with risk; rarely with promises.

That is why, when producing forecasts using Figurewizard, if a deficit for net current assets arises you would be well advised to go to the What-If Calculator / Planner to revise your input figures. Liquidity in the balance sheet should always be positive. 

How to Calculate Liquidity

When measuring liquidity, it is important to note that there are important distinctions between current assets and current liabilities.

Current assets are restricted to core trading assets such as accounts receivable, stock and pre-payments such as for rents, insurance and letters of credit. Current liabilities however are not so restricted.

For example, although fixed assets form no part of current assets, payments due within twelve months with respect to fixed asset financing are included in current liabilities. Repayments of external financing such as for loans of any kind falling due within twelve months are also defined as current liabilities.

Liquidity and the Bank

The bank overdraft is a current liability too. No matter how secure you may consider your arrangement with the bank may be, the rule is that bank overdrafts are repayable on demand.

How to Calculate Short Term Liquidity

A more searching definition of liquidity is the quick ratio; also known as the "acid test". Here it is calculated exactly as working capital but omitting the value of stock.

It's principal purpose is to check that stock levels are not so high that they can bring the sum of their cash convertibility within twelve months into question.

A working example of the acid test can also be viewed in the Figurewizard liquidity ratios forecast.

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