ACX3150 Financial Analysis And Valuation

Analysis of Liquidity Ratio

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Table of Contents

Introduction. 2

Discussion. 2

Conclusion. 4

Reference list 5

Introduction

At any given period of time, any business must have some assets as well as some liabilities. The current asset of a business contains prepaid expenses, cash equivalents, short-run investments, accounts receivable and inventories. Liquidity ratio in business refers to the measurement of the ability of a company to pay the obligations of debt as well as its safety margin by calculation of metrics. The liquidity analysis is very crucial for a firm because the creditors may understand the ability of the company to repay its debt so that the creditors may decide their future action. On the other hand, the management of the company may decide their strategies of future planning with the help of the liquidity analysis.

Discussion

Liquidity ratio in business refers to the measurement of the ability of a company to pay the obligations of debt as well as its safety margin by calculation of metrics. Metrics on the other hand includes the operating cash flow ratio (OCFR), quick ratio and current ratio. Now the term ‘liquidity’ implies the ability of an organization of converting its assets to cash, that also very cheap as well as quickly. This ratio is very useful in comparative form. This analysis is again divided into external and internal. Internal analysis of liquidity ratio deals with the use of the liquidity ratio for the analysis of the performance of the company in different accounting periods. Internal analysis helps to view the changes of the track of the business in different periods of time. External analysis is used to compare the LR of different companies. This external analysis helps the company to find its strategies for the other companies that are competitors of the firm. The liquidity analysis is very crucial for a firm because the creditors may understand the ability of the company to repay its debt so that the creditors may decide their future action. On the other hand, the management of the company may decide their strategies of future planning with the help of the liquidity analysis.

There are three types of liquidity ratios, namely, cash ratio, quick ratio and current ratio. These three ratios could have been described as follows.

Cash ratio: The cash ratio considers the assets of the company that are most liquid, for example, cash and marketable securities. The cash ratio is the ratio of the cash plus marketable securities and their current liabilities. This ratio indicates the capacity of the business to pay its short-run obligations.

Quick Ratio: Quick ratio is the ratio of cash plus accounts receivables plus marketable securities and current liabilities. As the quick ratio takes into account an asset that is more liquid that is account receivables as well as marketable securities and keeps aside current assets that are less liquid, this ratio is more reliable to the creditors.

Current ratio: Current ratio is the ratio of current assets and current liabilities. This is the simplest form of liquidity ratio that finds the company’s current assets.

The LRs are important to determine the ability of the business to repay its debt, creditworthiness and investment worthiness. These things are important for the functioning of the business as follows.

Ability to repay short-term debts: With the help of the liquidity ratios of a business, the investment can assess the ability of the firm to repay its loan. Higher the liquidity ratios higher will be the ability to repay debts, resulting in the higher investment to the form.

Creditworthiness: If the company has higher LRs, the creditors would be interested to increase the amount of the credit as the business has a greater ability to repay its debts.

Investment worthiness: If a business has higher liquidity ratios that imply the company is an economically healthy company. This would result in an increase in investments.

There is no specific rule for a business of how much liquidity it should have at a specific time. However, with the help of some statistics, it can be said that it should have operating expenses of three to six months. At any time a business should have some bank loans as well as some deposits with the banking sector. A bank calculates its liquidity risk at any specific time by the indicator of mismatch of loan as well as deposits with the bank. The activity of the bank is determined by the maturity transformation process that is very much exposed to the risk of maturity. It can be seen that income diversification, as well as savings banks, raises the risk of liquidity (Galletta, & Mazzù, 2019). Some interesting facts are revealed from some researches that find that the banks of some developing countries depend more on the liquidity which is asset-based as well as less on the liquidity which is liability based (Bhati, De Zoysa, & Jitaree, 2019). Some research empirically shows that there is some impact of leverage to mediate liquidity, profitability and firm size on the value of the firm (Zuhroh, 2019). Leverage in finance implies the ratio of debt and equity of a business. In the pandemic era, businesses all over the world have to face a huge crisis. Some researches show that the companies that are facing a crisis during the onset of the Covid-19 pandemic should conduct good liquidity management so that they can recover from the crisis (Jiang, 2020). Moreover, it can be said that the risk of liquidity may have an impact on the yield of bonds of a business (Febi et al., 2018)

Conclusion

Any business may have some assets as well as some liabilities. Liquidity ratio in business refers to the measurement of the ability of a company to pay the obligations of debt as well as its safety margin by calculation of metrics. The liquidity analysis is very crucial for a firm because the creditors may understand the ability of the company to repay its debt so that the creditors may decide their future action. On the other hand, the management of the company may decide their strategies of future planning with the help of the liquidity analysis. The liquidity analysis is important to find the ability of the business to repay its debt, creditworthiness and investment worthiness.

Reference list

Bhati, S. S., De Zoysa, A., & Jitaree, W. (2019). Factors affecting the liquidity of commercial banks in India: a longitudinal analysis. DOI: http://dx.doi.org/10.21511/bbs.14(4).2019.08

Febi, W., Schäfer, D., Stephan, A., & Sun, C. (2018). The impact of liquidity risk on the yield spread of green bonds. Finance Research Letters, 27, 53-59. DOI: https://doi.org/10.1016/j.frl.2018.02.025

Galletta, S., & Mazzù, S. (2019). Liquidity risk drivers and bank business models. Risks, 7(3), 89. DOI: https://doi.org/10.3390/risks7030089

Jiang, Y. (2020). Resource Integration, Risk Management and Liquidity Management Strategies. Proceedings of Business and Economic Studies, 3(5). DOI: https://doi.org/10.26689/pbes.v3i5.1525

Zuhroh, I. (2019). The Effects of Liquidity, Firm Size, and Profitability on the Firm Value with Mediating Leverage. KnE Social Sciences, 203-230. DOI: https://doi.org/10.18502/kss.v3i13.4206