Cash Liquidity Definition
Cash liquidity is an important measurement of a successful business. Good liquidity usually indicates that a business has good internal cash controls and solid accounting processes. Liquidity is also an important calculation for outside investors and banks; solid business operations will increase accounts receivable (A/R) and cash while keeping short-term liabilities in check.
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The Facts
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Cash is the most liquid asset a company has on its balance sheet. Other assets considered liquid include accounts receivable (A/R), marketable securities, and prepaid expenses. Assets that are easily converted into cash are generally considered liquid because they allow businesses to generate cash quickly during a cash shortage.
Calculating Cash Liquidity
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Several ratios are used when calculating a company's liquidity. Examples include:
Current Ratio = Current Assets / Current Liabilities
Simple calculation to determine a company's short-term cash position; the higher the number, the better a company can handle short-term cash needs.
Acid-Test Ratio = (Cash + A/R + Short-term Investments) / Current Liabilities
Uses the most liquid assets on the balance sheet to determine whether a company can afford its short term debt; inventory is not considered a liquid asset. Numbers over 1 are signs of a strong ratio.
Working Capital = Current Assets - Current Liabilities
This number determines whether a company has sufficient capital to pay short-term liabilities. High positive numbers indicate a strong cash position; declining working capital ratios over time indicates major cash shortages for a company. -
Importance of Cash Liquidity
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Liquidity is an important factor that investors use when gauging the overall health of a company. A strong cash position usually means debt is under control and any short-term liabilities can be paid off quickly in hard economic times. High liquidity ratios are also a sign that the company is generating sales and managing expenses, based on the size of A/R and cash on hand.
Managing Cash Liquidity
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Cash liquidity can be reviewed by the Vice President for Finance or the Treasury Manager of businesses. Calculating the cash ratios, reviewing loan agreements, and cash outflow reports are an important part of maintaining liquidity. Additionally, proper accounts payable functions and regular reconciling of all bank accounts will ensure no unauthorized cash outflows occur that negatively impact cash liquidity.
Benchmarking
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While cash liquidity is a very important part of business, it also helps to measure individual company liquidity versus the entire industry. While no set liquidity requirements exist for companies, comparisons to rival companies in an industry help determine how well a company is managing liquidity. Benchmarking to industry standards also aids management in gauging the health of a company's liquidity.
Additionally, benchmarking helps management understand the overall effectiveness of their cash controls and debt management. Benchmarks can also show management where failures are occurring in accounting processes and which cash controls should be improved.
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