How to calculate liquidity and short-term liquidity

Liquidity tells how well a business is placed to meet its financial liabilities. Short term liquidity tells how well it can do so from its own cash resources

Liquidity

The broad definition of liquidity is net current assets, also known as working capital. In the Figurewizard sample balance sheet forecast the value of working capital is £63,022.

It is calculated as current assets (cash plus cash convertible assets within twelve months) less current liabilities (all debt payable within twelve months). Examples of qualifying current assets are:

Cash
Factoring / Supply Chain Financing Credit Balances
Accounts Receivable
Stock / Inventory
Prepaid Expenses and Overheads
Prepaid Outstanding Letters of Credit
Payments in Advance


 

 

 

 

 

Short Term Liquidity

While liquidity describes the ability of a company's current assets to meet its short term liabilities, the one element that is not directly linked to cash receipts is stock / inventory.

If the level of stock to cash collectibles is too high or turning over too slowly it will inhibit liquidity and therefore cash flow in the short term. 

The Acid Test

As a result a more searching test is often applied to assess short term liquidity, known as the quick ratio or the acid test. Here the value of stock is ignored. For example; using the Figurewizard assets and liabilities forecast:

Current Assets 217,675
Current Liabilities 154,652
Net Current Assets / Working Capital 63.023
i.e. Current Ratio 1.41
Net Current Assets less Stock 92,675
Divide by Current Liabilities = Acid Test 0.60

 

 

 

 


Ideally the quick ratio / acid test should be at 1 or more but if working capital has a sufficient positive margin; i.e. well over 1, financing it in the short term should not be an insurmountable problem.

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