MSG Team's other articles

10033 Investment Banks and Governments

Governments all over the world regularly engage in high-value financial transactions. They often need the help of experts in order to do so. Since investment banks have a lot of experience in mediating high-value transactions, they are often appointed by the governments to be their advisors on these matters. In this article, we will have […]

9405 The Functions of a Financial System

Financial resources are scattered across the economy. This is the reason that there is a need for a financial system that can enable the timely deployment of these resources across different parts of the economy at the right time. A well-functioning financial system is supposed to perform several functions. Some of these functions have been […]

11815 What are Market Indices ?

Stock market indices are ubiquitous. People come across these indices almost every day. However, many are not aware about their existence. For instance everyone knows about NYSE, NASDAQ, FTSE, NIFTY etc. However, few are aware that they are referring to stock market indices when they talk about the markets going up or down. The New […]

8766 The Importance of Personal Finance

There is no shortage of education in the field of finance. There are various academicians who work tirelessly in the field of finance. Many theories have been developed, and many conjectures have been disproved. Every year thousands of people graduate with finance as their major. However, most of these people are trained in the field […]

9662 How Reserve Requirements Work ?

Reserve requirements are one of the most important features of modern central banking. We hear about reserve requirements almost every day in the media. When central banks like the Fed change these requirements, it is said to have a huge impact on the markets. Liquidity worth billions of dollars is said to be either released […]

Search with tags

  • No tags available.

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.

Liquidity is the Life of a Business

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.

Liquidity has an Impact on Long Term Survival of the Firm

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:

  • Banks Ask For Higher Interest Payments
  • Suppliers Are Wary Of Extending Credit
  • Attracting And Retaining Best Employees May Be As Issue

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.

Article Written by

MSG Team

An insightful writer passionate about sharing expertise, trends, and tips, dedicated to inspiring and informing readers through engaging and thoughtful content.

Leave a reply

Your email address will not be published. Required fields are marked *

Related Articles

What are Common Size Statements ?

MSG Team

Cash Ratio – Meaning, Formula and Assumptions

MSG Team