Question (5a)
you
adopt
to
business firm?
What
procedure
would
study
the liquidity of a
Answer: 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. A business that
collects its accounts receivable in an average of 20
days generally has more cash on hand than a
business that requires 45 days. Similarly, a business
that turns over its inventory 15 times a year has
more cash on hand than a company that turns its
inventory only 10 times a year. A business which
keeps surplus cash or an idle bank balance may be
readily able to meet its short-term or daily
obligations but it is not efectively utilizing its cash flow.
Another factor to determine the liquidity is to see the
profitability of the firm. The more profitable 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 capital to determine
the liquidity of the firm.
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Question 5 b:
interested
in
information?
Who are
knowing
all the
parties
this accounting
Answer:
The
various
parties
interested
in
determining the liquidity of the firm would be the
business
owners
and
managers,
bankers,
investors, creditors and financial analysts.
Business owners and managers use ratios to chart
a company's progress, uncover trends and point to
potential problem areas in a business. One can also
use ratios to compare your company's performance
with others within the industry.
Bankers and investors look at a company's ratios
when they are trying to decide if they want to lend
you money or invest in your company.
Creditors are interested in the companys short-term
and long-term ability to pay its debts.
Financial analysts, who frequently
specialize
in
following certain
industries, routinely
assess
the
profitability, liquidity, and solvency of companies in
order
to
make
recommendations
about
the
purchase or sale of securities,such as stocks and
bonds.
Question
financial
5c:
What
statement
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ratio
or
other
analysis technique
will you adopt for this.
Answer: The relevant ratios used to assess the
liquidity of the firm are current ratio, quick or acid
test ratio, cash ratio and net working capital.
Current
Ratio
Provides an
indication
of
the
liquidity of
the
business
by
comparing
the amount of
current
assets
to current liabilities. A business's
current
assets generally
consist
of
cash, marketable
securities,
accounts receivable,
and inventories.
Current liabilities include accounts payable, current
maturities of long-term debt, accrued income taxes,
and other accrued expenses that are
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due within one year. In general, businesses prefer to
have at least one dollar of current assets for every
dollar of current liabilities. However, the normal current
ratio fluctuates from industry to industry. A current
ratio significantly higher than the industry average
could indicate the existence of
redundant assets.
Conversely, a current ratio significantly lower than
the industry average could indicate a lack of liquidity.
Formu
la
Current
Assets
Current
Liabilities
Acid Test or Quick Ratio
A measurement of
the liquidity position of
the
business. The quick ratio compares the cash plus
cash equivalents and accounts receivable to the
current liabilities. The primary diference between the
current ratio and the quick ratio is the quick ratio
does not include inventory and prepaid expenses
in the calculation. Consequently, a business's quick
ratio
will
be lower than its current ratio. It is a
stringent test of liquidity.
F or m
ula
Cash + Marketable Securities +
Accounts Receivable
Current
Liabilities
Cash Ratio
Indicates a conservative view of liquidity such as
when a company has pledged its receivables and
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its inventory, or the analyst suspects severe
liquidity problems with inventory and receivables.
Formu
la
Cash Equivalents +
Marketable Securities
Current
Liabilities
Working Capital
Working capital compares current assets to current
liabilities, and serves as the liquid reserve available to
satisfy contingencies and uncertainties. A high working
capital 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
pay its current liabilities when due.
Formula
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Current Assets - Current Liabilities