Why Is Liquidity Such a Primary Factor?
It doesn’t do any good to be solvent if you’re 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 don’t 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 cash—what 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 company’s financial statements demonstrate its liquidity—current as of the date the statements were prepared. In other words, a company’s 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 doesn’t 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 you’ve got the ratios done, what do they mean? What should the owner be looking at, and what do investors check? You’ll 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 business’s profitability is increasing or decreasing and, in some cases, if a pattern is evident.
Common Statement Analysis: A Method for Analyzing Financial Statements
Investors ask companies to provide uniformity in their statements so that they can see how a company does compared with other similar companies. Choose a set time for analysis of liquidity is difficult because of the changing value of money as time passes. common size analysis and common base year analysis are two ways of looking at financial statements that guarantee uniformity across the board.