LIQUIDITY

Liquidity

Liquidity

Introduction

Scholes, Wilson and Wolfson, (2000, 625) had defined the concept of short-term liquidity of a firm as the degree to which the firm is able to meet its current obligations. Indirectly, liquidity implies the ability of the firm to convert assets into cash or to obtain cash from other sources as needed. For this purpose, it has become accepted to view "short-term" as a time span of up to one year, although it is sometimes identified with the normal operating cycle of the business. The importance of short-term liquidity may be illustrated by the potential repercussions arising from a firm's inability to meet its current obligations.

Reilly and Beauchaine (1999) had said that a business enterprise which experiences liquidity problems is unable to avail itself of favorable discounts and is not in a position to take advantage of profitable opportunities as they arise. This implies a lack of freedom in as well as constraints on management's decision making process. As the lack of liquidity becomes more serious, the firm is unable to pay its current debts and obligations. Eventually, the firm may be forced into insolvency, and, if appropriate measures are not taken, into liquidation.

O'Hara and Shaw (1990, 1587) had implied that to the owners of an enterprise, a lack of liquidity may result in a reduction in profitability, a loss of control, or a partial/total loss of equity. Obviously, the consequences of the latter are much more serious in situations without the limited liability protection. A lack of liquidity, to the creditors of the firm implies delays in the payment of interest and principal and, in the extreme, in partial or even total loss of the amount owed to them. Thus, it is evident that short-term liquidity is an extremely important factor in the financial health of a business enterprise.

Measurement of a firm's liquidity

Smith (1993, 50) said that the technology for measurement of liquidity has not changed much over the years. Traditional accounting ratios form a major portion of liquidity measurement. These ratios may be classified according to whether they measure the working capital position, working capital activity, or leverages.

The current ratio, quick ratio, net working capital ratio (current assets minus current liabilities) and the ratio of net working capital to current liabilities or total assets are the usual measures of working capital position. These ratios measure the extent to which currently maturing obligations are covered with current assets. Some of the reasons for the widespread use of the current ratio as a measure of liquidity are that it measures (Smith 1993, 59):

(a) Degree to which current assets cover current liabilities. The higher the current assets relative to current liabilities, the greater is the likelihood that the firm will be able to meet its short-term obligations:

(b) A buffer against possible losses, which could arise in the event of liquidation of current assets other than cash--the more substantial difference between current assets and current liabilities, the better it is for the creditors:

(c) The reserve of liquid funds ...