Scribd
Upload
135 views

Meaning and Importance of Liquidity: Financial Accounting

This document discusses short term liquidity and working capital in financial accounting. It defines liquidity as a company's ability to meet short term obligations by converting assets into cash. Maintaining adequate liquidity is important for companies to pay creditors on time, maintain good supplier relationships, and avoid bankruptcy. A company's liquidity can be analyzed using current assets, current liabilities, and working capital from its financial statements. Working capital is the excess of current assets over current liabilities, and higher positive working capital indicates better liquidity. Companies can manage liquidity and working capital through different financing decisions regarding current versus long term sources to fund current and non-current assets.

Uploaded by

rakeshganti
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
135 views

Meaning and Importance of Liquidity: Financial Accounting

This document discusses short term liquidity and working capital in financial accounting. It defines liquidity as a company's ability to meet short term obligations by converting assets into cash. Maintaining adequate liquidity is important for companies to pay creditors on time, maintain good supplier relationships, and avoid bankruptcy. A company's liquidity can be analyzed using current assets, current liabilities, and working capital from its financial statements. Working capital is the excess of current assets over current liabilities, and higher positive working capital indicates better liquidity. Companies can manage liquidity and working capital through different financing decisions regarding current versus long term sources to fund current and non-current assets.

Uploaded by

rakeshganti
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 3

Financial Accounting

Short Term Liquidity

MEANING AND IMPORTANCE OF LIQUIDITY Liquidity is the ability of a company to meet the short term obligations. It is the ability of the company to convert its assets into cash. Short term, generally, signifies obligations which mature within one accounting year. Short term also reflects the operating cycle: buying, manufacturing, selling, and collecting. A company that cannot pay its creditors on time and continue not to honor its obligations to the suppliers of credit, services, and goods can be declared a sick company or bankrupt company. Inability to meet the short term liabilities may affect the companys operations and in many cases it may affect its reputation too. Lack of cash or liquid assets on hand may force a company to miss the incentives given by the suppliers of credit, services, and goods. Loss of such incentives may result in higher cost of goods which in turn affect the profitability of the business. So there is always a need for the company to maintain certain degree of liquidity. However, there is no standard norm for liquidity. It depends on the nature of the business, scale of operations, location of the business and many other factors. Every stakeholder has interest in the liquidity position of a company. Supplier of goods will check the liquidity of the company before selling goods on credit. Employees are also have interest in the liquidity to know whether the company can meet its employees related obligations: salary, pension, provident fund etc. Shareholders are interested in understanding the liquidity due to its huge impact on the profitability. Shareholders may not like high liquidity as profitability and liquidity are inversely related. However, shareholders are also aware that non-liquidity will deprive the company from getting incentives from the suppliers, creditors, and bankers. Liquidity and Business Decisions One can understand the liquidity position by analyzing the financial statements of a company. Following financial items are required to understood to understand the liquidity position of a company: Current Assets Current Liabilities Liquidity position of a company can examined through financing decisions or investment decisions. A company can finance its investment by different combination of current and long term sources. In other words, a company can invest the money, raised through short term source or long term sources, in the current assets or non-current assts. Some of the relevant business strategies are as follows: Financing the current assets by current sources Financing the current assets by the long term sources Financing non-current assets by the short term sources Financing non-current assets by long term sources One can get an idea about the above mentioned decisions by seeing the balance sheet or determining the working capital of a company.

Liquidity and Working Capital


1

Financial Accounting

Short Term Liquidity

As mentioned in the previous section, working capital helps in understanding the liquidity position of a company. It also shows the financing or investment decisions of a company. Working capital is the excess of current assets over the current liabilities. So working capital of a company can take one of the following directions: Positive working capital: When current assets are more than the current liabilities Negative working capital: When the current liabilities are more than the current assets Zero working capital: when the current assets are equal to the current liabilities Conventionally, it is accepted that higher the positive working capital, better is the liquidity position. The rationale of this position is that the it is easier to sell off the current assets and make the payment towards the current liabilities. Let us see the relationship between the working capital and other components of the balance sheet. Sources = Assets Or Owners fund + Long Term borrowings + Current Liabilities = Current Assts + Non-Current Assets Or Long Term funds + Current Liabilities = Current Assets + Non-current assets Or Long Term funds = Current Assets + Non-Current Assets- Current Liabilities Or Long term funds Non Current Assets = Current Assets Current Liabilities

Or Long Term Funds Non-Current Assets = Working Capital

So managing working is not just managing current assets and current liabilities. One can manage the working capital by managing the long term funds and non-current assets. In other words, liquidity of a company can be managed by managing current assets, current liabilities, non-current assets, and long term funds. Therefore, one can also explain the working capital from the financing angle as follows: Positive working capital: When current assets are partly financed by the long term funds. Negative working capital: When the non-current assets are partly financed by the current liabilities. Zero working capital: when the current assets fully financed by the current liabilities and the non-current assets are fully financed by the long term finds Table 15.1 shows the working capital of some of the well known companies of India
2

Financial Accounting

Short Term Liquidity

Table 15.1
Working Capital as % of Total Funds as on 31 March 2006 (Rs. in crores) WC Satyam Computer Services Ltd. Sun Pharmaceutical Inds. Ltd. Reliance Energy Ltd. Suzlon Energy Ltd. Dr. Reddy'S Laboratories Ltd. Prowess: CMIE Database 3760 2334 8213 2435 1743 % 74% 65% 56% 54% 45% I T C Ltd. Indian Petrochemicals Corpn. Ltd. Reliance Industries Ltd. Grasim Industries Ltd. Videsh Sanchar Nigam Ltd. WC 1427.26 1128.26 8094.97 753.39 603.69 % 11% 11% 9% 9% 8%

You might also like

pFad - Phonifier reborn

Pfad - The Proxy pFad of © 2024 Garber Painting. All rights reserved.

Note: This service is not intended for secure transactions such as banking, social media, email, or purchasing. Use at your own risk. We assume no liability whatsoever for broken pages.


Alternative Proxies:

Alternative Proxy

pFad Proxy

pFad v3 Proxy

pFad v4 Proxy