ebay beats headphones Guide to Performing a Liquidity Analysis
The Fluidity of Liquidity
Some people feel a great deal of confusion by the complex and confusing glossary of the financial business world, and understanding liquidity analysis is a perfect example. The term actually means just what it sounds like: The liquidity of your finances, meaning your ability to utilize money in a timely fashion to meet financial situations that arise.
Liquidity is different from solvency. A business is considered liquid if its assets are sufficient and are sufficiently convertible to cover liabilities. Liquidity implies that the owners fluid ability to convert assets will convince investors or bankers to loan money to the business.
Liquidity problems occur when, for example, the business owner cannot convert assets into cash quickly enough to cover liabilities as needed. However, the fact that he has assets might convince lenders to help him out in given situations. The businesss combination or ratio of assets to liabilities keeps it liquid.
What Information Do Liquidity Ratios Provide?
If it wants to succeed, a business must be able to meet its regular demands as well as any unexpected expenses that come up. Liquidity is determined by dividing current assets by current liabilities. If someone has assets in the amount of $300,000 and liabilities of $100,000, the liquidity ratio will be 3. A ratio of 1.5 or higher is positive.
An Example of a Basic Balance Sheet
Where does the business owner get these figuresthe total assets and liabilities? They are figures, along with others, found on the balance sheet. Of course, the ratio is a little more complicated than assets divided by liabilities. Youve got to take your assets and subtract current inventory. Your liabilities should include your equity. This article links you to a free downloadable template for a balance sheet.
Ratio Analysis of Financial Statements
You keep hearing about ratios, but a companys trustworthiness or value must be crunched into a number so that investors and lenders can make decisions about the company. Those numbers help the owner make decisions about cash on hand, accounts receivables, and much more. Learn here how the business owner can reach a liquidity ratio and give it the proper weight. Likewise, he must look at profitability ratios to see if, over a longer term, profitability remains dependable. Take a look, also, at efficiency ratios and long term solvency ratios.
Exactly What Is Solvency?
Solvency problems, on the other hand, arise when the business simply does not have the money or the assets to cover its debts. The most common example occurs when a company does not have the assets to back up its request to borrow money or its needs to raise money quickly for specific situations. When a business owner gets into trouble and he has no financial options to save his business,
he is insolvent.
Overview of Solvency Ratio Analysis
Reviewing your solvency helps you determine if youve gotten too far deeply into debt to remain viable if disaster strikes. Learn about the debt ratio, which is the reverse of the liquidity ratioliabilities divided by assets. You will be able to see if too much of the money on your books comes from creditors rather than investors, which is not a good sign. Your ratio should be no greater than 0.5, although the acceptable number can vary according to industry.
Why Is Liquidity Such a Primary Factor?
It doesnt do any good to be solvent if youre not liquid. What should a company do if it has a large cash reserve? Your immediate recommendation might be investment in more capital equipment. After all, if a factory has a bigger assembly line, it can turn out more gadgets, which means more sales.
But what if the market for gadgets drops? People just dont want them anymore. The business owner who sank all his money into producing more of them will be in sorry shape.
Suppose the business owner decides to split the extra cash. Some of it, yes, he invests into capital equipment and expansion. But much of it will go into short term investments. If the owner suddenly finds a need for cashwhat if a tornado strikes the factory and blows away all his equipment?he can convert his investment back into cash and remain solvent. He has maintained his liquidity.
How Liquidity Affects Market Value and Book Value of an Investment
The companys financial statements demonstrate its liquiditycurrent as of the date the statements were prepared. In other words, a companys financial state is constantly changing with day to day market conditions. If a company has a high liquidity ratio, investors are more likely to feel comfortable putting their own money into that company.
Learning Guide: Interpret and Use Ratios
Here you will come to understand why a business manager should deal in ratios rather than just the figures. The owner can plan strategies to increase production or pull back till inventory is sold. The banker will decide that if the company is sufficiently liquid to cover any needs that arise, the company will be a worthwhile investment.
Acid Test Ratio: Examples and Calculation
For purposes of calculating liquidity, the acid test ratio excludes inventory as an asset. After all, investors consider that even if the company doesnt sell another gadget, they still want to recover their investment or loan. For this purpose the assets will include only cash, short term investments, and accounts receivables.
Interpreting the Liquidity Ratio
Once youve got the ratios done, what do they mean? What should the owner be looking at, and what do investors check? Youll find useful examples here such as a company that holds high amounts of cash on hand. Why is that not a good thing? That means the owner is not putting the cash to work for the business, neither investing in capital equipment nor in short term high yield investments. When accounts receivables are too high, that means the owner needs to coax his debtors into paying up or else slow down on the credit he extends.
Analysis of Common Size Financial Statements
A common size financial statement dispenses with the exact amounts of assets and liabilities. Instead, the owner chooses a year to use as a base or benchmark for the business and its ratios are represented at a value of 100%. Numbers for subsequent years are also converted to percentages. The person who is reviewing the financial statement will be able to see if the businesss profitability is increasing or decreasing and, in some cases,
if a pattern is evident.