FINANCIAL ANALYSIS

Financial analysis is the selection, evaluation, and interpretation of financial data,

along with other pertinent (relevant) information, to assist in assessing the risk and return

associated with an investment. Financial analysis may be used to evaluate the efficiency of

operations, the effectiveness of credit policies, and the creditworthiness of a company,

among other things.

The analyst draws the financial data needed in financial analysis from many

sources. The primary source is the data provided by the company itself in its annual report

and required disclosures. The annual report and the 10-K filing include the income

statement, the balance sheet, and the statement of cash flows, as well as footnotes to these

statements.

Besides information that companies are required to disclose through financial

statements, other information is readily available for financial analysis. For example,

information such as the market prices of securities of publicly traded corporations can be

found in the financial press and the electronic media daily. Similarly, information on stock

price indices for industries and for the market as a whole is available in the financial press.

Another source of information is economic data, such as the Gross Domestic

Product (GDP) and Consumer Price Index (CPI), which may be useful in assessing the

recent performance or future prospects of a company or industry. Suppose you are

evaluating a company that owns a chain of retail outlets.

 Many tools are available for use when evaluating a company, but some of the most

valuable are financial ratios. Ratios are an analyst’s microscope; they allow us to get a

better view of the firm’s financial health than just looking at the raw financial statements.

What is a ratios?

A ratio is a comparison of two numbers by division. We could also compare

numbers by subtraction, but a ratio is superior in most cases because it is a measure of

relative size. Relative measures are more easily compared to previous time periods or other

firms than changes in dollar amounts.

Ratios are useful to both internal and external analysts of the firm. For internal

purposes, ratios can be useful in planning for the future, setting goals, and evaluating the

performance of managers.

External analysts use ratios to decide whether or not to grant credit, to monitor

financial performance, to forecast financial performance, and to decide whether to invest

in the company. We will look at many different ratios, but you should be aware that these

are, of necessity, only a sampling of the ratios that might be useful. Furthermore, different

analysts may calculate ratios slightly differently, so you will need to know exactly how the

ratios are calculated in a given situation. The keys to understanding ratio analysis are

experience and an analytical mind.

We will divide our discussion of the ratios into five categories based on the information

provided:

1. Liquidity ratios describe the ability of a firm to meets its short-term obligations. They

compare current assets to current liabilities.

2. Efficiency ratios describe how well the firm is using its investment in various types of

assets to produce sales. They may also be called asset management ratios.

3. Leverage ratios reveal the degree to which debt has been used to finance the firm’s

asset purchases. These ratios are also known as debt management ratios.

4. Coverage ratios are similar to liquidity ratios in that they describe the ability of a firm

to pay certain expenses.

5. Profitability ratios provide indications of how profitable a firm has been over a period

of time

1. Liquidity Ratios

The term “liquidity” refers to the speed with which an asset can be converted into

cash without large discounts to its value. Some assets, such as accounts receivable, can

easily be converted into cash with only small discounts. Other assets, such as buildings,

can be converted into cash very quickly only if large price concessions are given. We

therefore say that accounts receivable are more liquid than buildings
 All other things being equal, a firm with more liquid assets will be more able to meet

its maturing obligations (e.g., its accounts payable and other short-term debts) than a firm

with fewer liquid assets. As you might imagine, creditors are particularly concerned with

a firm’s ability to pay its bills. To assess this ability, it is common to use the current ratio

and/or the quick ratio.

a. The Current Ratio

Generally, a firm’s current assets are converted to cash (e.g., collecting on accounts

receivable or selling its inventories) and this cash is used to retire its current liabilities.

Therefore, it is logical to assess a firm’s ability to pay its bills by comparing the size of its

current assets to the size of its current liabilities. The current ratio does exactly this. It is

defined as:

Current Ratio = Current Assets /Current Liabilities

Obviously, the higher the current ratio, the higher the likelihood that a firm will be able

to pay its bills. So, from the creditor’s point of view, higher is better. However, from a

shareholder’s point of view this is not always the case. Current assets usually have a lower

expected return than do fixed assets, so the shareholders would like to see that only the

minimum amount of the company’s capital is invested in current assets. Of course, too little

investment in current assets could be disastrous for both creditors and owners of the firm
 b. The Quick Ratio

Inventories are often the least liquid of the firm’s current assets. For this reason, many

believe that a better measure of liquidity can be obtained by excluding inventories. The

result is known as the quick ratio (sometimes called the acid-test ratio) and is calculated as

Quick Ratio= Current Assets – Inventories /Current Liabilities

2. Efficiency Ratios

Efficiency ratios, also called asset management ratios, provide information about how

well the company is using its assets to generate sales. For example, if two firms have the

same level of sales, but one has a lower investment in inventories, we would say that the

firm with lower inventories is more efficient with respect to its inventory management.

There are many different types of efficiency ratios that could be defined. However, we will

illustrate five of the most common

a. Inventory Turnover Ratio

The inventory turnover ratio measures the number of dollars of sales that are generated

per dollar of inventory. It can also be interpreted as the number of times that a firm replaces

its inventories during a year. It is calculated as:

Inventory Turnover Ratio =Cost of Goods Sold/ Inventory

Note that it is also common to use sales in the numerator. Because the only difference

between sales and cost of goods sold is a markup (i.e., profit margin), this causes no
problems. In addition, you will frequently see the average level of inventories throughout

the year in the denominator. Whenever using ratios, you need to be aware of the method of

calculation to be sure that you are comparing “apples to apples.”

b. Accounts Receivable Turnover Ratio

Businesses grant credit to customers for one main reason: to increase sales. It is

important, therefore, to know how well the firm is managing its accounts receivable. The

accounts receivable turnover ratio (and the average collection period) provides us with this

information. It is calculated by:

Accounts Receivable Turnover Ratio =Credit Sales/ Accounts Receivable

c. Average Collection Period

The average collection period (also known as day’s sales outstanding, or DSO) tells

us how many days, on average, it takes to collect on a credit sale. It is calculated as follows

Average Collection Period= Accounts Receivable /Credit Sales

d. Fixed Asset Turnover Ratio

The fixed asset turnover ratio describes the dollar amount of sales that are generated by

each dollar invested in fixed assets. It is given by

Fixed Asset Turnover= Sales Net /Fixed Assets

 e. Total Asset Turnover Ratio

Like the other ratios discussed in this section, the total asset turnover ratio describes how

efficiently the firm is using all of its assets to generate sales. In this case, we look at the

firm’s total asset investment:

Total Asset Turnover =Sales /Total Asset

3. LEVERAGE RATIOS

In physics, leverage refers to a multiplication of force. Using a lever and pivot, you

can press down on one end of a lever with a given force and get a larger force at the other

end. The amount of leverage depends on the length of the lever and the position of the

pivot. In finance, leverage refers to a multiplication of changes in profitability measures.

For example, a 10% increase in sales might lead to a 20% increase in net income. The

amount of leverage depends on the amount of debt that a firm uses to finance its operations,

so a firm that uses a lot of debt is said to be highly leveraged.

Leverage ratios describe the degree to which the firm uses debt in its capital

structure. This is important information for creditors and investors in the firm. Creditors

might be concerned that a firm has too much debt and will therefore have difficulty in

repaying loans. Investors might be concerned because a large amount of debt can lead to a

large amount of volatility in the firm’s earnings. However, most firms use some debt. This

is because the tax deductibility of interest can increase the wealth of the firm’s

shareholders. We will examine several ratios that help to determine the amount of debt that

a firm is using. How much is too much depends on the nature of the business.
 a. The Total Debt Ratio

The total debt ratio measures the total amount of debt (long-term and short-term)

that the firm uses to finance its assets

Total Debt Ratio= Total Liabilities/ Total Assets = Total Assets– Total Equity / Total

Assets

b. The Long-Term Debt Ratio

Many analysts believe that it is more useful to focus on just the long-term debt

(LTD) instead of total debt. The long-term debt ratio is the same as the total debt ratio,

except that the numerator includes only long-term debt

Long-Term Debt Ratio= Long-Term Debt /Total Assets

c. The Debt to Equity Ratio

The debt to equity ratio provides exactly the same information as the total debt ratio, but

in a slightly different form that some analysts prefer

Debt to Equity =Total Debt /Total Equity

4. PROFITABILITY RATIOS

Investors, and therefore managers, are particularly interested in the profitability of

the firms that they own. As we’ll see, there are many ways to measure profits. Profitability

ratios provide an easy way to compare profits to earlier periods or to other firms.
Furthermore, by simultaneously examining the first three profitability ratios, an analyst can

discover categories of expenses that may be out of line.

Profitability ratios are the easiest of all the ratios to analyze. Without exception,

high ratios are preferred. However, the definition of high depends on the industry in which

the firm operates. Generally, firms in mature industries with lots of competition will have

lower profitability measures than firms in faster growing industries with less competition.

For example, grocery stores will have lower profit margins than computer software

companies. In the grocery business, a net profit margin of 3% would be considered quite

well. That same margin would be abysmal in the software business, where 15% or higher

is common.

a. The Gross Profit Margin

The gross profit margin measures the gross profit relative to sales. It indicates the

amount of funds available to pay the firm’s expenses other than its cost of sales. The gross

profit margin is calculated by

Gross Profit Margin= Gross Profit /Sales

b. The Operating Profit Margin

Moving down the income statement, we can calculate the profits that remain after

the firm has paid all of its operating (nonfinancial) expenses. The operating profit margin

is calculated as

Operating Profit Margin =Net Operating/ Income Sales

 c. The Net Profit Margin

The net profit margin relates net income to sales. Because net income is profit after

all expenses, the net profit margin tells us the percentage of sales that remains for the

shareholders of the firm:

Net Profit Margin Net = Income /Sales

d. Return on Total Assets

The total assets of a firm are the investment that the shareholders have made. Much

like you might be interested in the returns generated by your investments, analysts are often

interested in the return that a firm is able to get from its investments. The return on total

assets is

Return on Total Assets= Net Income / Total Assets

e. Return on Equity

While total assets represent the total investment in the firm, the owners’ investment

(common stock and retained earnings) usually represent only a portion of this amount

(some is debt). For this reason, it is useful to calculate the rate of return on the shareholder’s

invested funds. We can calculate the return on (total) equity as

Return on Equity= Net Income /Total Equity

f. Return on Common Equity

For firms that have issued preferred stock in addition to common stock, it is often

helpful to determine the rate of return on just the common stockholders’ investment
 Return on Common Equity = Net Income Available to Common/ Common

Equity

OPERATING ASSETS AND OPERATING CAPITAL

Operating assets are assets that are used in normal business operations. They are

not held for resale to customers. Investments in operating assets are essential to the success

of most businesses.

There are three major categories of operating assets: property, plant, and

equipment, sometimes referred to as plant assets or fixed assets; natural resources; and

intangible assets.

Property, plant, and equipment includes land; land improvements, such as

driveways, parking lots, fences, and similar items that require periodic repair and

replacement; buildings; equipment; vehicles; and furniture. Natural resources, such as

timber, fossil fuels, and mineral deposits, are created by natural processes that may take

thousands or even millions of years to complete. Companies use up natural resources by

cutting or extracting them, so natural resources are sometimes called wasting assets.

Intangible assets, which lack physical substance, may nevertheless provide substantial

value to a company. Patents, copyrights, and trademarks are examples of intangible assets.
OPERATING CAPITAL

Definition

The operating capital definition is the cash used for daily operations in a company. As a

result, it is essential to the survival of each and every business. Whether small or large,

across industries, and under any other conditions that a business faces, lack of cash is one

of the main reasons why a company fails. Due to this fact, it is of key importance that

businesses monitor and plan for future cash holdings to assure that the business will have

the money needed to continue doing business.

Operating capital, explained as the most essential asset in any business, allows

a company to stay open. Also known as working capital, it can come from many

sources. Operating capital verses working capital is a similar there is no difference.

For an existing business, operating capital outlay will come from more providers than for

the startup. The same options exist with current owners, friends and family, banks and the

S.B.A., and more. Additionally, however, a business can receive operating capital loans

from mezzanine financiers, factoring, or becoming a public company and selling stock on

the open market.

Operating Capital Formula

Though the operating capital formula is a simple function of subtraction it is actually

quite complicated. The difficult part of operating capital requirements is the research
associated with finding current asset and current liability amounts. Once these questions

are answered the operating capital ratio comes naturally.

Operating Capital = Current Assets – Current Liabilities

Operating Capital Example

For example, Chris is the CFO of a large company – a series of retail stores which

sell plants for home decor. Chris plans the company finances to assure smooth operations.

This includes managing company operating capital.

Recently, the company has experienced enormous growth. While this is a great

signal that the business model is sound, it can also form a operating capital crisis.

Consequently, Chris must move forward carefully to avoid financial ruin for the company.

First, Chris wants to know where the company stands. He then performs this working

capital calculation to see where the business is currently:

Current Assets = $1,000,000

Current Liabilities = $250,000

Operating Capital = $1,000,000 – $250,000 = $750,000

Chris knows that $750,000 is not enough money to get the company through this quarter.

He also knows that with insufficient working capital the company will have to seek

financing from a lender who is less risk averse

MARKET VALUE ADDED (MVA) AND ECONOMIC VALUE ADDED (EVA)

Market value added (MVA) and economic value added (EVA) are calculations

used to measure the value of a company. These metrics are useful for business owners

because they highlight whether the firm is doing well or performing poorly. The metrics

can also guide decision-makers as they consider possible strategies for increasing the

company's value.

Market Value Added

To calculate the MVA, subtract the total investment in the company from its total market

value. You can compute a company's total market value by adding the market value of

its equity to the book value of its debt. Another way to imagine MVA is to consider the

amount that investors put into the company and then determine how much they could

make if they disposed of all their shares. The difference between these two is the MVA.

The larger the figure, the greater the maximization of shareholder value.

MVA Formula

MVA = Market Value of Shares – Book Value of Shareholders’ Equity

To find the market value of shares, simply multiply the outstanding shares by the current

market price per share. If a company offers owns preferred and ordinary shares, then the

two are summed together to find the total market value.

Example,

Company ABC whose shareholders’ equity amounts to $900,000. The company owns

7,000 preferred shares and 200,000 common shares outstanding.

The present market value for the common shares is $13.50 per share and $100 per share

for the preferred shares.

Market Value of Common Shares = 150,000 * $13.50 = $2,025,000

Market Value of Preferred Shares = 9,000 * $100 = $900,000

Total Market Value of Shares = $2,025,000 + $900,000 = $2,925,000

Using the figures obtained above:

Market Value Added = $2725, 000 – 900,000 = $1,825,000

Economic Value Added

To calculate the EVA, you'll need to determine the capital charges, operating profit and

the net operating profit after taxes. You can calculate the value of capital charges by

multiplying invested capital and the weighted average cost of capital. Subtract the

operating expenses from net sales to get the operating profit. Next, compute the by

subtracting taxes. Now, subtract capital charges from Net operating profit after taxes to

arrive at the EVA.

EVA is computed by subtracting the product of the company’s initial capital and

the percentage cost of capital from its after-tax net profit.

Example

Company ABC generated after-tax net profits amounting to $300,000 in 2019. The

amount of capital the company invested was $2 million at an average cost of capital of

10%. To calculate ABC’s EVA:

 $300,000 – ($2,000,000 * 10%) = $20,000

The $20,000 figure implies that Company ABC generated enough profits to cover its

initial cost of conducting business.

ANALYZING RETURN ON ASSETS: THE DU PONT SYSTEM

DEFINITION

Return on assets or ROA is a profitability ratio measuring the efficiency of a company’s

management to generate net income by its total assets. in other words, it shows the dollar

amount of net income generated by $1 invested in assets. since roa measures the efficiency

of assets, using it is an important metric for both management and investors.

FORMULA OF ROA

The return on assets ratio formula is calculated by dividing net income by average total

assets

This ratio can also be represented as a product of the profit margin and the total asset

turnover.

Either formula can be used to calculate the return on total assets. When using the first

formula, average total assets are usually used because asset totals can vary throughout the

year. Simply add the beginning and ending assets together on the balance sheet and divide

by two to calculate the average assets for the year. It might be obvious, but it is important
to mention that average total assets is the historical cost of the assets on the balance sheet

without taking into consideration the accumulated depreciation.

The net income can be found on the income statement

The formula of return on assets is expressed as follows:

Net income
ROA = × 100%
Average total assets

The return on assets ratio, often called the return on total assets, is a profitability

ratio that measures the net income produced by total assets during a period by comparing

net income to the average total assets. In other words, the return on assets ratio or ROA

measures how efficiently a company can manage its assets to produce profits during a

period.

Since company assets’ sole purpose is to generate revenues and produce profits,

this ratio helps both management and investors see how well the company can convert its

investments in assets into profits. You can look at ROA as a return on investment for the

company since capital assets are often the biggest investment for most companies. in this

case, the company invests money into capital assets and the return is measured in profits.
ANALYSIS

Return on assets ratio works best to compare companies working in the same

industry because asset utilization can significantly differ depending on the industry. For

example, the automotive industry is characterized by lots of complicated and expensive

equipment being used, while a software company uses fewer assets to generate income and

profit.

While the ROA ratio isn’t recommended to compare the performance of companies

working in different industries, it should be compared with the industry average. Doing

this helps to determine whether or not asset profitability is better than average in the

industry. The return on assets ratio measures how effectively a company can earn a return

on its investment in assets. In other words, ROA shows how efficiently a company can

convert the money used to purchase assets into net income or profits.

Since all assets are either funded by equity or debt, some investors try to disregard the costs

of acquiring the assets in the return calculation by adding back interest expense in the

formula.

It only makes sense that a higher ratio is more favorable to investors because it

shows that the company is more effectively managing its assets to produce greater amounts

of net income. A positive ROA ratio usually indicates an upward profit trend as well. ROA

is most useful for comparing companies in the same industry as different industries use

assets differently. For instance, construction companies use large, expensive equipment

while software companies use computers and servers.

EXAMPLE

Charlie’s construction company is a growing construction business that has a few contracts

to build storefronts in downtown Chicago. Charlie’s balance sheet shows beginning assets

of $1,000,000 and an ending balance of $2,000,000 of assets. During the current year,

Charlie’s company had net income of $20,000,000. Charlie’s return on assets ratio looks

like this.

20,000,000
ROA = × 100%
1,000,000+2,000,000

=1333.33%

As you can see, Charlie’s ratio is 1,333.3 percent. In other words, every dollar that Charlie

invested in assets during the year produced $13.3 of net income. Depending on the

economy, this can be a healthy return rate no matter what the investment is.

Investors would have to compare Charlie’s return with other construction companies in his

industry to get a true understanding of how well Charlie is managing his assets.

MEASURING LEVERAGE

Leverage is the amount of fixed costs a firm has. Fixed costs, which are costs that

remain the same irrespective of a company’s sales or level of production, include both

operating costs (rent/depreciation) and financial costs (e.g. interest expense).

Definitions of Leverage:

Some definitions are given to have a clear idea about leverage:

• According to Ezra Solomon: “Leverage is the ratio of net returns on shareholders equity

and the net rate of return on capitalisation”.

• According to J. C. Van Home: “Leverage is the employment of an asset or funds for

which the firm pays a fixed cost of fixed return

TYPES OF LEVERAGE:

There are three types major Leverage which are:

(i) Operating leverage

(ii) Financial leverage

(iii) Combined leverage

OPERATING LEVERAGE:

Operating leverage refers to the use of fixed operating costs such as depreciation,

insurance of assets, repairs and maintenance, property taxes etc. in the operations of a

firm. But it does not include interest on debt capital. Higher the proportion of fixed

operating cost as compared to variable cost, higher is the operating leverage, and vice

versa.

IMPORTANCE OF OPERATING LEVERAGE:

1. It gives an idea about the impact of changes in sales on the operating income of the

firm.
2. High degree of operating leverage magnifies the effect on EBIT for a small change in

the sales volume.

3. High degree of operating leverage indicates increase in operating profit or EBIT.

4. High operating leverage results from the existence of a higher amount of fixed costs in

the total cost structure of a firm which makes the margin of safety low.

5. High operating leverage indicates higher amount of sales required to reach break-even

point.

6. Higher fixed operating cost in the total cost structure of a firm promotes higher

operating leverage and its operating risk. 7. A lower operating leverage gives enough

cushion to the firm by providing a high margin of safety against variation in sales.

2. FINANCIAL LEVERAGE:

Financial leverage is primarily concerned with the financial activities which involve

raising of funds from the sources for which a firm has to bear fixed charges such as

interest expenses, loan fees etc. These sources include long-term debt (i.e., debentures,

bonds etc.) and preference share capital.

THE IMPORTANCE OF FINANCIAL LEVERAGE:

1. It helps the financial manager to design an optimum capital structure

2. It increases earning per share (EPS) as well as financial risk.

3. A high financial leverage indicates existence of high financial fixed costs and high

financial risk.

4. It helps to bring balance between financial risk and return in the capital structure.
5. It shows the excess on return on investment over the fixed cost on the use of the funds.

6. It is an important tool in the hands of the finance manager while determining the

amount of debt in the capital structure of the firm.

3. COMBINED LEVERAGE:

Operating leverage shows the operating risk and is measured by the percentage change in

earn before interest tax (EBIT due to percentage change in sales. The financial leverage

shows the financial risk and is measured by the percentage change in EPS due to

percentage change in EBIT.

IMPORTANCE OF COMBINED LEVERAGE:

1. It indicates the effect that changes in sales will have on EPS.

2. It shows the combined effect of operating leverage and financial leverage.

3. A combination of high operating leverage and a high financial leverage is very risky

situation because the combined effect of the two leverages is a multiple of these two

leverages.

4. A combination of high operating leverage and a low financial leverage indicates that the

management should be careful as the high risk involved in the former is balanced by the

later.

5. A combination of low operating leverage and a high financial leverage gives a better

situation for maximising return and minimising risk factor, because keeping the operating

leverage at low rate full advantage of debt financing can be taken to maximise return. In

this situation the firm reaches its BEP at a low level of sales with minimum business risk.
6. A combination of low operating leverage and low financial leverage indicates that the

firm losses profitable opportunities

MEASURING LIQUIDITY

What is liquidity?

It’s the ability to convert an asset into cash as quickly as possible (preferably within

90 days). This is why any asset that possesses this ability is also referred to as a liquid asset.

Keep in mind, though, that it’s not just your ability to sell, it’s also your ability to sell at

favorable terms, which is a simple factor which tends to make things much more complex.

Not only is this important for you to understand but it’s also something that can affect the

way in which you invest. In other words, it can be a predominant factor for you when

you’re coming up with an overall investment strategy

Liquidity relates to quick access to cash. Individuals hold assets or security, and

liquidity refers to the ease with which these may be bought or sold in the market for

conversion into cash.

Cash is held to be the standard for liquidity as it can be converted to other assets most

easily. It can be measured by two methods – market liquidity and accounting liquidity.

Types of Liquid Assets

Liquid assets are such assets held by businesses or individuals, which can be converted

into cash quickly. It can include cash, marketable securities as well as money market

instruments. All such assets are reflected in the balance sheet of the company.
Cash and savings accounts usually retain the highest form of liquidity that may be

owned either by businesses or individuals. The following assets can also be liquidated

easily

 Cash

The total amount of money, which is accessible, is a form of liquid asset. Cash can be

utilised to resolve any existing liabilities. Cash in an account will also be considered as

liquid since it can be withdrawn for settling obligations at any time.

 Cash equivalents

Cash equivalents are usually highly liquid investments which have maturity ranging up

to only 3 months. It has substantial credit quality and may be immediately used owing

to lack of any restriction. Examples of cash equivalent include commercial papers and

treasury bills, amongst others.

 Accrued income

The income that one has already earned, but the amount is yet to be deposited in the

associated account is accrued income. In such a case, the delayed income is expected to

arrive any day, making it a liquid source of funding.

 Stocks

A stock market is categorized to be liquid due to the existence of a high number of

buyers and sellers. One can sell off their owned stocks quickly through electronic

markets. Thus, according to the demand, an individual or business can convert equity

securities into cash quickly.

 Therefore, owning a considerable pool of equity shares is a sign of liquidity in

stocks for a particular individual or company.

 Government bonds

Governments may raise funds through bonds wherein investors extend a loan to the

government by way of a debt instrument in lieu of an interest rate. Investors stand to

gain assured returns at periodic intervals.

Government bonds are primarily held to be fixed-income assets. An investor receives

the original investment on the maturity date. However, maturity tenures differ from one

bond to another. Similar to stocks, government bonds may be held as an investment or

traded in the open market.

For example, a government bond of 5 years’ period may have reached only half of its

term when the investor notices a more attractive investment opportunity elsewhere. In

such situations, the investor has the option to sell the government bond to another

investor recovering the original quantum.

 Promissory notes

Promissory notes are primarily signed documents indicating a written promise to pay

the specified sum of money to the recipient on a particular date. This financial

instrument is a promise to repay a debt to the payee.

Such promissory notes act as an alternative source of funding for individuals who do not

want to deal with a bank. The financing party may be a corporation as well as an

individual, which on mutually agreed terms, carries the note and initiates financing.
 Accounts receivable

Accounts receivable refer to invoices and bills that a company has already generated for

its consumers, but has yet to receive the payments settling such bills. The unpaid balance

amounts to being assets for the particular company.

Liquidity example, in this case, involves unpaid invoices of an electric company

amounts to accounts receivable for the electricity provided to its customers. The account

receivables are liquidated on payment of electricity bills.

 Marketable securities

Publicly listed companies may issue short-term financial instruments linked with debt

or equity securities for the purpose of raising funds, which are known as marketable

securities. These instruments are primarily used to finance business expansions or other

activities. The debt securities are also issued by the government for carrying out public

projects or funding public expenditures. Such debt securities may include Treasury Bills.

Marketable securities usually have short maturity periods like 11 months which makes

the liquidation of these investments easy as opposed to securities that have long-term

maturity periods. Most common examples of such financial instruments are bonds,

stocks, exchange-traded funds and preferred shares amongst others.

 Certificate of deposits

Certificate of deposit entitles the holder of such investment product to a lump sum

amount, including the principal and the interest accrued on the principal. The certificate
of deposit will lead to liquidity in reaching the maturity period. It amounts to a special

kind of savings instrument, which freezes the interest rate, term period, principal, and

the bank or the credit institution after it is opened.

Liquidation of a certificate of deposits before the maturity period will attract penalty,

and the penalty amount usually depends on the term period.

Different Methods for Measuring Liquidity

Market Liquidity

Market liquidity indicates such condition of the market when assets may be purchased

or sold off quickly. Such liquidity is particularly evident in the case of real estate or

financial market. The conversion of assets into cash across markets is also referred to

as liquidity in economics.

The market for equities or stocks can be held to be liquid only if the purchase and selling

of shares can happen quickly with minimal impact on the price of the shares. The shares

that are traded on big stock exchanges are usually found to be liquid.

Accounting Liquidity

The ease with which a company or an individual is capable of meeting financial

obligations, using liquid assets constitutes accounting liquidity. It involves the

comparison of the liquid assets held by the company or an individual to that of current

liabilities in a financial year. Accounting liquidity may be measured by current ratio and

cash ratio.

Current ratio is also referred to as working capital that takes into account the current

assets that may be liquidated into cash within a financial year.

Current ratio = current assent /current liability

On the contrary, cash ratio measures the cash flow that will meet the current liabilities.

It is usually an indicator of short-term liquidity.

Cash Ratio = Cash (or equivalents) + Investments (short-term) / Current liabilities

Liquidity is important for individuals, corporations, as well as markets. In spite of

holding high-value assets, any of these entities may experience liquidity crunch if such

assets cannot be converted into cash within a short period. It may so happen that there

may be distress selling of assets in order to meet the liquidity demands or short -term

obligations