What is Ratio Analysis ?
Ratio analysis is one of the oldest methods of financial statements analysis. It was developed by banks and other lenders to help them chose amongst competing companies asking for their credit. Two sets of financial statements can be difficult to compare. The effect of time, of being in different industries and having different styles of […]
How Sporting Franchises Help Billionaires to Plan Their Taxes
Over the years, the sporting business has quietly metamorphosized into a big business. The amount of money changing hands in the sports business today would have been considered unthinkable even a few years ago. It is common for franchises to be valued in billions of dollars. Star players also make millions of dollars while playing […]
How to Identify an Overvalued Market?
All stock market investors know that markets go through periods of euphoria and panic. During periods of euphoria, investors keep on buying shares in the hope of a higher payoff. In technical terms, this is the situation wherein the entire market becomes overvalued. The opposite of this also happens when fear grips the market, everybody […]
Five Reasons Which Make Cryptocurrency a Bad Investment
The incredible rise in the price of cryptocurrencies in the past few months has caught the interest of almost every investor in the entire world. Even the most traditional investors have been introduced to the concept of cryptocurrencies. However, not all investors want to invest in it. For instance, Warren Buffet has famously stated that […]
What is Venture Leasing? – Advantages and Disadvantages
In the previous few articles, we have already learned about how venture capital and venture debt work. We now also know the pros and cons of venture debt. However, there is another form of debt called venture leasing which is commonly used by investors in the marketplace. In this article, we will have a closer […]
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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