Accounting for manager- semester-1

1. Question 5) What procedure would you adopt to study the liquidity of a business firm?
Who are all the parties interested in knowing this accounting information?
What ratio or other financial statement analysis technique will you adopt for this.
Answer: Liquidity is the ability of the firm to convert assets into cash. It is also called marketability or
short-term solvency. In other words, it is the ability of the firm to meet its day-to-day obligations.
In order to study the liquidity of the firm, we need to thoroughly examine its asset structure, mainly
the current assets. The current assets, viz: stock, debtors, bank balance and other current assets
need to be seen to determine at what rate a firm can convert these into cash.A business that collects
its accounts receivable in an average of 20 days generally has more cash on hand than a business
that requires 45 days. Similarly, a business that turns over its inventory 15 times a year has more
cash on hand than a company that turns its inventory only 10 times a year. A business which
keeps surplus cash or an idle bank balance may be readily able to meet its short-term or daily
obligations but it is not effectively utilizing its cash flow. Another factor to determine the liquidity is to
see the profitability of the firm. The more profitable the firm is, the more cash resourcesit shall have.
Last, but not the least, we use make use of certain financial ratios like current ratio, quick or
acid-test ratio, net working capital to determine the liquidity of the firm.
The various parties interested in determining the liquidity of the firm would be the business
owners and managers, bankers, investors, creditors and financial analysts.
Business owners and managers use ratios to chart a company's progress, uncover trends and point
to potential problem areas in a business. One can also use ratios to compare your company's
performance with others within the industry.
Bankers and investors look at a company's ratios when they are trying to decide if they want to
lend you money or invest in your company. Creditors are interested in the company’s short-term and
long-term ability to pay its debts.
Financial analysts, who frequently specialize in following certain industries, routinely assess the
profitability, liquidity, and solvency of companies in order to make recommendations about the
purchase or sale of securities, such as stocks and bonds.
The relevant ratios used to assess the liquidity of the firm are current ratio, quick or acid – test
ratio, cash ratio and net working capital.
Current Ratio :
Provides an indication of the liquidity of the business by comparing the amount of current assets
to current liabilities. A business's current assets generally consist of cash, marketable securities,
accounts receivable, and inventories. Current liabilities include accounts payable, current maturities of

2. long-term debt, accrued income taxes, and other accrued expenses that are due within one year. In
general, businesses prefer tohave at least one dollar of current assets for every dollar of current
liabilities. However, the normal current ratio fluctuates from industry to industry. A current ratio
significantly higher than the industry average could indicate the existence of redundant assets.
Conversely, a current ratio significantly lower than the industry average could indicate a lack of
liquidity.
Formula = (Current Assets)/ (Current Liabilities)
Acid Test or Quick Ratio
A measurement of the liquidity position of the business. The quick ratio compares the cash plus
cash equivalents and accounts receivable to the current liabilities. The primary difference
between the current ratio and the quick ratio is the quick ratio does not include inventory and
prepaid expenses in the calculation. Consequently, a business's quick ratio will be lower than its
current ratio. It is a stringent test of liquidity.
Formula = (Cash + Marketable Securities + Accounts Receivable) / (Current Liabilities)
Cash Ratio
Indicates a conservative view of liquidity such as whena company has pledged its receivables and its
inventory, or the analyst suspects severe liquidity problems with inventory and receivables.
Formula = (Cash Equivalents + Marketable Securities)/(Current Liabilities )
Working Capital
Working capital compares current assets to current liabilities, and serves as the liquid reserve available
to satisfy contingencies and uncertainties. A high working capital balance is mandated if the entity is
unable to borrow on short notice. The ratio indicates the short-term solvency of a business and in
determining if a firm can pay its current liabilities when due.
Formula = Current Assets - Current Liabilities