In a rapidly changing business world, liquidity is one of the fundamental pillars of the viability and success of an enterprise. But exactly what is liquidity in accounting, and why is it vital to the financial life of companies? Imagine a fast-growing company that has huge assets and growing profits but suddenly finds itself unable to pay its due bills or employees’ salaries. Profitability is not enough to ensure financial sustainability if there is not enough liquidity, so in this article, we will delve into the concept of liquidity, its importance, and how to manage it efficiently to ensure that companies remain strong and stable in the face of financial challenges. Follow us.
What is liquidity in accounting?
It is one of the important concepts in the world of business and investment, which refers to the ability to convert assets into cash easily and without significant impact on their prices. It also reflects the ability of a company or individual to meet their short-term financial obligations. Liquidity in accounting can be divided into two main types:
Market liquidity
It is the ease with which the market allows for buying and selling assets at fixed prices. Assets with high liquidity in the market can be easily bought or sold without a significant change in their prices.
Accounting liquidity
Accounting liquidity is a measure that indicates the ease with which a company or individual can pay their financial obligations using the assets they have available. This information can be found in the company’s balance sheet, as assets are displayed according to their ability to be converted into cash.
Liquidity risk
These are important risks that must be taken into consideration by investors and financial institutions. They represent the risk of not being able to convert assets into cash in a timely manner and without significant loss. These risks arise as a result of several factors, including:
- There is a lack of a sufficient number of buyers and sellers in the market to execute transactions quickly and at reasonable prices.
- Poor liquidity of the asset itself is due to a lack of trading in it or the presence of restrictions on trading.
- Crises and disturbances in financial markets, which lead to a decline in confidence and a decrease in liquidity.
- There are large fluctuations in asset prices, which makes it difficult to evaluate them and predict their prices.
It is worth noting that liquidity risk represents the possibility of incurring losses as a result of selling an asset at a price significantly lower than its fair value or the inability to obtain the necessary financing in a timely manner and at an acceptable cost.
Notice
To face these risks, it is recommended to diversify the investment portfolio and allocate part of it to highly liquid assets, in addition to maintaining sufficient levels of liquidity with financial institutions. The investor must also have a good understanding of the nature of the assets in which he invests and their liquidity in the market.
The importance of liquidity ratios
The liquidity ratio in accounting is one of the most important financial indicators that helps investors and decision-makers evaluate the financial position of the company. The following are the main points about the importance of this ratio:
Measuring the company’s ability to manage crises
Liquidity ratios measure the company’s readiness to face financial crises by determining its ability to pay its obligations in the short term, and thus, this increases the confidence of those dealing with the company.
Protection from financial default
Measuring liquidity ratios helps avoid falling into a state of financial default by monitoring the company’s ability to pay its obligations.
Providing insights to investors and decision-makers
Liquidity ratios provide important information about the company’s ability to meet its short-term financial obligations, which helps investors and other stakeholders better evaluate the company’s financial position.
Take advantage of cash discounts.
Companies with high liquidity can benefit from cash discounts when paying their obligations to banks and creditors early.
Building the company’s financial reputation
Companies with high liquidity ratios have a good financial reputation and are in a better competitive position compared to competitors.
Ensuring continuity of operational operations
Maintain appropriate liquidity levels that lead to the ability to meet financial obligations such as payment of wages, obligations, and the purchase of goods, thereby ensuring continuity of production and operation.
Maintaining cash flow
Maintaining high liquidity ratios helps ensure that a company’s cash inflow exceeds its outflow.
Types of liquidity ratios
There are many types of liquidity ratios in accounting that are used to evaluate the facility’s ability to meet its short-term obligations. It is worth noting that each ratio has its advantages and focuses on a specific aspect of liquidity, which helps financial analysts comprehensively evaluate the facility’s financial position. These types are as follows:
Quick ratio
This ratio measures the facility’s ability to pay its short-term obligations using the most liquid current assets, such as cash and securities that can be quickly converted into cash, and is calculated by dividing the total cash and marketable securities by the total current liabilities.
This ratio is a good indicator of an entity’s ability to pay its short-term obligations in a timely manner.
An example of quick ratio calculation
If your total current liabilities are 30,000 Saudi riyals, the inventory is estimated at 20,000 Saudi riyals, and the total current assets are 30,000 Saudi riyals, as well as the prepaid expenses of 10,000 Saudi riyals, then the quick ratio calculation is equal to 0.9, which indicates that the organization can cover current liabilities by an estimated 90%..
Cash ratio
This ratio measures the facility’s ability to pay its current liabilities using cash and quasi-cash assets only and is calculated by dividing the total cash and quasi-cash assets by the total current liabilities.
This ratio is an indicator of the facility’s immediate liquidity and its ability to meet its short-term obligations without the need to sell other assets.
Current ratio
This ratio measures the facility’s ability to pay its current obligations using all current assets and is calculated by dividing the total current assets by the total current liabilities. It is worth noting that this ratio is a general indicator of liquidity and the facility’s ability to meet its short-term obligations.
An example of calculating the current ratio
If your total current liabilities are 20,000 Saudi riyals and your total current assets are 36,000 Saudi riyals, then the trading ratio here is 1.8.
Operating cash flow ratio
This ratio shows the company’s ability to generate cash flows from its operational activities to cover its short-term obligations. It is calculated by dividing the net cash flows from operating activities by the total current liabilities, and it is considered a good ratio when it is greater than 1.
Net working capital
This indicator shows the difference between current assets and current liabilities, which represents the company’s net working capital. It is also an indicator of the company’s ability to pay its short-term obligations using its current assets, and the higher the number, the better for the company.
Steps to create a working capital entry via the Qoyod website
If you want to create an entry for adding working capital via the Qoyod accounting program, all you have to do is follow the following steps:
- From the Accounting drop-down menu, choose Manual Entries.
- You will then be taken to the main page for manual entries. Click on the + sign at the top left of the page.
- You will see several fields for creating a new manual entry.
- Fill in these fields with the necessary information, and add other accounts by clicking Add Account.
- Finally, click Save to be able to add the account.
Cash coverage ratio for daily cash needs
This ratio shows the company’s ability to pay its short-term obligations through its cash and quasi-cash assets. It is calculated by dividing the total cash and quasi-cash assets by the average daily obligations. The ratio is considered good if it is greater than 1.
How to Calculate Liquidity Ratios
Liquidity ratios in accounting are a set of financial metrics that are used to evaluate a company’s ability to pay its short-term financial obligations using its current assets. These ratios are one of the most important financial indicators that financial analysts and investors must consider.
Now, let’s take a practical example of a company called “S” that is in the business of importing and exporting. Let us assume that the company has the following numbers on its balance sheet:
- Current assets: 1,000,000 riyals.
- Inventory: 300,000 riyals.
- Cash: 200,000 riyals.
- Current liabilities: 600,000 riyals.
Using this data, we can calculate the company’s liquidity ratios:
- Current ratio = 1,000,000 / 600,000 = 1.67.
- Quick ratios = (1,000,000 – 300,000) / 600,000 = 1.17.
- Cash ratio = 200,000 / 600,000 = 0.33.
Through these results, we can interpret the liquidity position of Company “S” as follows:
- A current ratio of 1.67 indicates that the company has the ability to pay its short-term obligations using its current assets.
- Quick ratios of 1.17 indicate that the company has the ability to pay off its short-term obligations using its most liquid assets.
- A cash ratio of 0.33 indicates that the company has one-third of the value of its short-term liabilities in the form of cash and cash equivalents.
Overall, Company X’s liquidity ratios are good, indicating a strong financial position capable of paying short-term obligations.
How to increase liquidity ratios in accounting
By implementing these measures in an integrated manner, the company will be able to increase its liquidity ratios and significantly improve its financial position. These measures are as follows:
- Paying attention to activity ratios and inventory management: Monitoring and improving inventory turnover rates helps free up working capital and increase liquidity.
- Paying urgent obligations regularly: Ensuring that obligations are paid on time helps maintain the company’s credit reputation and avoid fines.
- Long-term financing: Seeking long-term financing such as loans and bonds helps improve the budget structure and increase liquidity.
- Reducing obligations and expenses: Reviewing fixed expenses and costs such as rents, salaries, and operating expenses and working to reduce them as much as possible leads to increasing liquidity.
- Transfer Accounts: Use temporary transfer accounts to convert unused cash balances into highly liquid short-term investments.
A sample of types of financial ratios
If you would like to download the Types of Financial Ratios form, simply click here.
Conclusion
Liquidity in accounting is not just a number on the books of accounts but rather the lifeblood of any organization seeking growth and sustainability, the ability to move quickly and exploit opportunities, and the ability to the ability to protect the company from unexpected financial shocks. In a rapidly changing world, liquidity has become a vital element that can determine the fate of organizations between sustainable success and rapid failure. Therefore, companies must enhance their understanding and management of liquidity to ensure they stay ahead of the competition and take advantage of every opportunity to achieve progress and prosperity. It is worth noting that it is one of the most important measures of the company’s financial performance and constitutes a major element in evaluating its ability to meet its short-term obligations, and its analysis requires an in-depth understanding of the factors affecting it, such as capital structure, sources of financing, as well as cash and investment management.
Accountants and financial managers must take care to manage liquidity effectively to ensure the continuity of the company’s business and its long-term growth, and this is only possible with the Qoyod program. It is worth noting that it also offers all its clients: electronic invoice systems, as well as point-of-sale systems, warehouses, customers, etc., which makes it the best integrated accounting program.
After you know what liquidity is in accounting, try Qoyod now for free for 14 days, because it is an accounting program that achieves what you want and more at the lowest prices.
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