Job Costing and Service Firms
Law Firms: Law firms all across the world practice job costing. Most law firms charge an hourly rate to their clients. This rate is derived on the basis of the same factors direct material, direct labour as well as overheads. In case of law firms, the direct material used is negligible. The majority of the […]
The Amazon FedEx Breakup
Amazon and FedEx have traditionally had a love-hate relationship. On the one hand, Amazon is one of the biggest customers of FedEx, whereas, on the other hand, it is also one of their biggest competitors. Amazon has already made its intentions clear. In the long run, they do not want to be associated with FedEx, […]
Interest Rates and Automobile Sales
The automobile industry sales have been stagnant for the past couple of years. However, this is bad news. This is because almost all industries in the world have seen an extended bull run. The world has seen some of the lowest financing costs in history over the past decade or so. Hence, it can be […]
Pension Funds and the Use of Derivatives
Pension funds across the world are meant to be low-risk financial instruments. They are allowed to take slightly more risks in some parts of the world as compared to others. However, for the most part, pension fund across the world is advised to stay away from risky instruments such as derivatives. Derivatives have been known […]
Zero-Coupon Bonds: Pros and Cons
Zero-coupon bonds are those bonds that are sold at a deep discount to their face value. This means that these bonds do not receive any periodic interest. Instead, the investors have to invest a lump sum amount at the beginning of their investment and get paid a higher lumpsum amount at the end of their […]
Liquidity can be defined as the ability of a firm to make good its short term obligations. Most businesses function on credit. Hence to run a business firms have to both extend credit as well as ensure that they receive credit as well.
Liquidity ratios measure the relationship between the amounts of short term capital that the firm has locked in its receivables versus the short term interest free debt it has acquired in the form of accounts payables.
Liquidity ratios can be defined as the ratios which help analysts predict the short term solvency of the firm. Short term here is meant to be considered the period until the next business cycle which is usually 12 months.
A firm seldom has all the resources it needs to run the business. It gets credit from its employees, suppliers, customers, the government and such other entities. Each of these entities extends credit to the firm on the assumption that it will make good its obligations when they are due. Such obligations are usually due in the short term.
Investors are therefore very cautious about ascertaining whether the firm does in fact have the capability to meet these obligations. Liquidity ratios help in ascertaining this. With secondary data that is available in the annual reports of the company, analysts often make projections about whether the company has enough resources to survive the short run without hampering its reputation or operations.
Amateur investors think liquidity is primarily short term. It does not matter whether or not the company can pay its immediate bills, if the long term prospects of the company look good, it is a good investment. This is the farthest from the truth as history has shown liquidity issues can have far reaching effects on the health of a firm sometimes even endangering the very survival of the firm. Here is how it happens:
As a result of all these, present profitability is compromised and so are the future growth plans of the company which now has to seek funds at extremely high costs.
The best example of how liquidity problems can wreak havoc and threaten the very survival of a firm is the recent Kingfisher Airlines fiasco where the firm had to shut down operations because it could not meet its short term obligations.
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