Liquidity is a company’s ability to raise cash when it needs it.
There are two major determinants of a company’s liquidity position. The first is its ability to convert assets to cash to pay its current liabilities (short-term liquidity). The second is its debt capacity. Debt capacity is a company’s ability to service its current debt load as well as its ability to raise cash through new debt.
Short-term liquidity is calculated from the following measures and ratios:
- Working capital
- Acid-test ratio
- Current ratio
- Payables turnover
- Average collection period
- Inventory turnover
Debt capacity is calculated from these ratios:
All nine measures need to be evaluated together to get the full picture of a business’s ability to raise cash. A business would also want to benchmark each measure against those of other companies in its industry to get a complete understanding of its financial health.