Chapter 4, Learning Activities

1. Coverage of FSA ratios in terms of Liquidity

2. Significance of Liquidity
 liquidity refers to how easily an asset can be converted into cash without affecting
the market price. It’s obvious then that cash is the most liquid asset you can have,
particularly of a relatively stable currency like USD. In comparison, an asset with
lower liquidity would be something less simple to convert cash. An example would
be large assets such as plant, property, and equipment. Imagine you’re a minerals
company and have a digger worth $5 million, you couldn’t just sell it tomorrow if
you needed that money to pay off an outstanding debt.
 The Most Liquid Assets, As we mentioned before, cash is the most liquid asset you
can own. Stocks and bonds are the non-cash assets which can also be most easily
converted into cash. The higher the trade volume is for a stock or bond, the more
liquid it is. This is because higher trade volume indicates that the asset is easily
traded for the market price. In practice what this means is that the bid-offer-spread
(the difference between the bid price and ask price) is low. Investment assets are
next on the liquidity scale. This includes restricted or preferred shares which often
have restrictions or terms upon which they can be sold. This makes them slower to
convert into cash and hence less liquid.
 The Least Liquid Assets, Collectable items such as coins, stamps, and art are fairly
illiquid (opposite of liquid). Owners of these items could get the true value for the
items if they shop around enough for the right buyer. However, if they need the
cash quickly they will likely have to sell at a discounted price. Clearly this reduces
the liquidity of this type of asset. However, should demand for an item suddenly
increase (e.g. a new trend for a particular artist) the liquidity could be reassessed.
Plant, property, and equipment are even further down on the liquidity scale for the
reasons mentioned in the introduction. Examples of this are the real estate,
machinery or tools, and raw materials. The very least liquid assets (generally
speaking) are businesses that the company owns. These are most difficult to sell
because of the high degree of complexity involved in the sale.
 When assessing the health of a company, understanding the company’s liquidity is
important for gauging how able a firm is to pay its short term debts and current
liabilities. Any cash left over can be used to pay dividends to shareholders and grow
the firm. Liquidity is measured using ratios such as cash ratio, current ratio, and
more. Liquidity is the ability to convert an asset into cash easily and without losing
money against the market price. The easier it is for an asset to turn into cash, the
more liquid it is. Liquidity is important for learning how easily a company can pay off
it’s short term liabilities and debts
Concept Application:

a. Liquidity Ratios

i. Current Ratio = Current Assets

Current Liabilities

2015 2014

= 59,850 = 18,720
19,900 15,600

= 3.00 : 1 = 1.2 : 1

In 2015, Current Ratio is 3:1. This means that for every 1 peso of liability, the company has 3
pesos of Current Asset to pay its currently maturing obligations, while in 2014, the current ratio is 1.2:1,
this means that for every 1 peso of liabilities, the company has 1 pesos and 20 centavos to pay its
currently maturing obligations.

*a high current ratio does not necessarily mean that the company is able to meet its current
maturing debts and a low current ratio may be able to pay current maturing debts, because the
composition of its current asses is easily convertible to cash like having collectible receivables and highly
saleable trading securities. Current Ratio’s significance could be best evaluated by comparing this with
industry competitors or the company’s trend of liquidity over a longer period (5 years).

b. Acid Test / Quick Asset Ratio

Acid Test / Quick Asset Ratio = Quick Assets (Cash&cash equivalents + Trade Securities + Acc.
Receivables)
Current Liabilities

2015 2014

= 24890+10000+16000 = 2,120+6000
19,900 15,600

= 2.55 : 1 = 0.5205 : 1

In 2015, Quick asset ratio is 2.55:1. This means that for every 1 peso of liabilities, the company 2
pesos and 55 centavos quick assets to pay its currently maturing obligations, while in 2014, quick asset
ratio is 0.5205:1, this means that, for every 1 peso of liabilities, the company has only 52 centavos quick
assets to pay its currently maturing debt. Therefore, in 2014, the company isn’t liquid enough to pay its
currently maturing debt.

*Inventories is not included in the computation because of its uncertainty as to when the item
will be converted to cash. The higher the quick ratio, the more liquid the firm is and thus, can pay its
current maturing debt/obligations.