Liquidity refers to the ability of a company to satisfy its short-term obligations using assets that can be readily converted to cash. Liquidity depends on both the type of asset and the speed at which it can be converted to cash.

Even though long-term assets may also be converted to cash to improve liquidity, it has other costs for a company, for example, it may impair a company's financial strength.

There are two sources of liquidity. The main difference between the two sources is whether or not the company's normal operations will be affected.

• Primary sources of liquidity include cash, short-term funds, and cash flow management. These resources represent funds that are readily accessible at relatively low cost.

• Secondary sources include negotiating debt contracts, liquidating assets, and filing for bankruptcy and reorganization. They provide liquidity at a higher price and may impact a company's financial and operating positions.

Drags and Pulls on Liquidity

The timing of cash receipts and disbursements can significantly affect a company's liquidity position.

A drag on liquidity exists when cash inflows lag.

• Uncollected receivables: For an analyst, the drags are often visible from an analysis of balance sheet trends and ratios. For example, a deterioration in days sales outstanding (DSO) is often an indication of negative developments acting as drags on liquidity. Increasing levels of bad debt expenses are also a useful indicator to identify issues in the collection of receivables.

• Inventory obsolescence: If a company's inventory is turning obsolete, it will experience a drag on liquidity as the value of such inventory declines, turning into lower cash inflows than planned. A good indication of increasing inventory obsolescence is often given by slowing inventory turnover ratios.

• Tight credit: If access to capital worsens or becomes more expensive, a company's liquidity may worsen.

A pull on liquidity is generated when cash outflows happen too quickly or when a company's access to commercial or financial credit is limited.

• Early payments: A company that pays its suppliers, creditors, or employees before the payment is due is creating a pull on liquidity. It is a commonplace among companies to hold payments until the due date without any anticipation of payments.

• Reduced credit limits: Consider a company fails to pay its obligations to its suppliers on a timely basis, or willingly takes advantage of its suppliers by paying after a long delay. In such cases, suppliers may decide to reduce the amount of trade credit to the company - impacting its liquidity.

• Reduced lines of credit: As a supplier can reduce the amount of credit to a customer, banks can also reduce the amount of credit available to their customers. It can be due to company-specific reasons, such as deteriorating business trends in the company or in the bank itself. In other cases, it can be a response to a customer's poor track record of debt repayment. The reductions may be mandated by governments or may be due to conditions in the credit markets, such as tighter access to funds from central banks.

• Low liquidity positions.

Liquidity Ratios

Liquidity ratios measure the ability of a company to meet future short-term financial obligations from current assets and, more importantly, cash flows. Each of the following ratios takes a slightly different view of cash or near-cash items.

• Current Ratio is a measure of the number of dollars of current assets available to meet current obligations. It is the best-known liquidity measure. A current ratio of less than 1 indicates the company has negative working capital.
  

• Quick Ratio (Acid-Test Ratio) eliminates less liquid assets, such as inventory and pre-paid expenses, from the current ratio. If inventory is not moving, the quick ratio is a better indicator of cash and near-cash items that will be available to meet current obligations.
  

• Cash Ratio is the most conservative liquidity ratio, determined by eliminating receivables from the quick ratio. As with the elimination of inventory in the quick ratio, there is no guarantee that the receivables will be collected.