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CORPORATE

LIQUIDITY

PREPARED BY:-
RAJESH SHARMA
MBA 0741

By Rajesh Sharma 1
INTRODUCTION
The term liquidity probably brings to mind the relationship
of current assets to current liabilities. An essential
component of liquidity is the time an asset takes to be
converted into cash or the time it takes to pay a current
liability. More simply, this may be stated as the ability of
the firm to pay its bills on time. Liquidity may also be
viewed as the ability of the firm to augment its future cash
flows to cover any unforeseen needs or to take advantage
of any unforeseen opportunities. This concept of liquidity
has been referred to as financial flexibility.

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TRADITIONAL MEASURES OF
LIQUIDITY

Although the ratio presented in this section are


generally referred to as liquidity ratio, most of
them especially the current and quick ratios,
really measure the solvency of the firm.

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LIQUIDITY RATIO
Liquidity and short term solvency ratios are used to judge
the firm’s ability to meet such current obligations as its
accounts payable and the current position of its long-term
debt. By interpreting such ratios we can determine the
degree to which assets which are quickly convertible to
cash exceed the liabilities which require almost immediate
cash payment. Liquidity ratios are generally useful to all
financial statement users, but are particularly useful to
short-term creditors. The most frequently ratios in this
category are:-

1. CURRENT RATIO
2. QUICK (ACID TEST) RATIO

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CURRENT RATIO
The current ratio is the traditional ratio used to measure a
company’s liquidity and is calculated by dividing the total
current assets by the total current liabilities.

CURRENT RATIO = Current Assets / Current Liabilities


Current Assets:-
Cash in hand, cash at bank, sundry
debtors, bills receivables (B/R),
inventory, prepaid expenses, accrued
income etc.
Current Liabilities:-
Bank overdraft, sundry creditors,
outstanding expenses (o/s exp.), bills
payable (B/P), income received in
advance etc.

By Rajesh Sharma IDLE RATIO = 2:1 5


QUICK (ACID TEST) RATIO
A supplementary test of the ability of a business to meet its
current obligation is the quick or the acid test ratio. The
quick ratio is calculated by dividing the liquid assets by
current liabilities.

QUICK RATIO = Liquid Assets / Current Liabilities


Liquid Assets:-
Current Assets – Inventory
Current Liabilities:-
Bank overdraft, sundry creditors,
outstanding expenses (o/s exp.), bills
payable (B/P), income received in
advance etc.

IDLE RATIO = 1:1

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ACTIVITY RATIO
Activity ratios reflect the intensity with which the firm uses
assets in generating sales. If investment in an asset is too
large, it could be that the funds tied up in that asset should
be used for more immediate productive purpose. If
investment is too small, the firm may be providing poor
service to the customers or inefficiently, providing its
product. Some of the activity ratios, which are also referred
to as efficiency or turnover are discussed below:-

1. Receivable Turnover Ratio


2. Inventory Turnover Ratio

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RECEIVABLE TURNOVER RATIO
The sundry debtors turnover is a measure of the number of
times on the average that receivables turnover each year.
This ratio is computed by dividing net credit sales by the
average receivable outstanding during the year. Average
sundry debtors are calculated by taking the average of the
current and previous year-end sundry debtors balances.

DEBTORS TURNOVER RATIO = Net Credit Sales / Average


Debtors

AVERAGE COLLECTION PERIOD IN DAYS


=Number of Days in a Year / Debtors Turnover Ratio

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INVENTORY TURNOVER RATIO

Inventory turnover is a measure of the number of times the


average inventory has been sold during the year. It is
computed by dividing the cost of goods sold by the average
inventory.

INVENTORY TURNOVER RATIO = Cost of Goods Sold /


Average Inventory

AVERAGE INVENTORY TURNOVER IN DAYS


= Number of Days in a Year /
Inventory Turnover Ratio

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NET WORKING CAPITAL

Another common liquidity measure is net working capital.


Net working capital is the difference between current assets
and current liabilities. It is generally agreed that the
greater the current assets relative to the level of current
liabilities, the more liquid the company.

NET WORKING CAPITAL = Current Assets – Current


Liabilities

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WORKING CAPITAL APPROACH
Working capital is defined as current assets minus current
liabilities. It is a broader definition of “funds” than just
cash, but bear in mind that cash is one component of
working capital. The statement of changes in financial
position on a working capital basis includes information
relating to the changes in working capital based on the
various sources and uses of funds.
The statement of sources and uses of capital gives a
picture pf management’s handling of circulating capital. It
is, therefore, a “window” through which the analyst can
closely examine one phase of management’s planning and
decision making

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SOURCES AND USES OF WORKING
CAPITAL
The statement of changes in financial position is divided
into two major segments: funds that the firm has obtained
during the period (sources of funds) and the outflow of
funds which has occurred (use of funds). The “sources of
funds” section summarises all transactions of the business
that caused an increase in working capital.

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SOURCES OF WORKING CAPITAL
Transactions that increase working capital are sources of
funds. The primary sources of working capital of a firm
include:
FUNDS GENERATED FROM OPERATIONS:

The earning of a business represent one of the principal


‘sources of funds’. The amount of funds generated from
operations is not the net income shown on the income
statement, however, because some of expenses, principally
depreciation and amortisation, do not involve the
expenditure of funds. In order to determine working capital
provided by operations, it is necessary to deduct from
revenues those expenses which required an expenditure of
funds and therefore caused a decrease in working capital.

COMPUTAION OF WORKING CAPITAL FUND PROVIDED BY


OPERATIONS = Net Income + Items Reducing Net Income
Which Do Not Affect Working Capital + Non Operating
Losses – Non Operating Gains – Items Increasing Net
Income Which Do Not Affect Working Capital
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SOME SOURCES OF FUNDS
 Increase in long-term liabilities
 Increase in share capital
 Sale of non current assets etc.

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USES OF FUNDS

Transactions that decrease working capital are classifies as


uses of funds. Typically uses of working capital include:-
 Purchase of non current assets
 Dividends
 Decrease in long-term liabilities etc.

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TRANSACTIONS THAT INCREASE
WORKING CAPITAL
S. No. Type of Example Working Capital Effect
Transactions
1. Long-Term Assets Sale of a Fixed Assets Increase in Cash or Receivable
to Current Assets (e.g. Mach.) equal to the proceed of sale
2. Long-Term Issuance of Increase in cash equal to
Liabilities to Current Debenture debenture issued.
Assets
3. Owner’s Equity to Earning of Profit Increase in Cash and Receivables
Current Assets from Revenue Less Current Assets
Consumed and Payments and
Accruals for Current Expenses

4. Long-Term Assets Transfer of a Long- Decrease in Current Liability equal


to Current Liabilities Term Asset to amount of Debt Satisfied

5. Current Liabilities in Exchange of Current Decrease in Creditor equal to


Long-Term Creditor in debenture amount of debenture issued.
Liabilities
6. Current Liabilities to Insurance of Shares Decrease in Current Liability Equal
Owner’s Equity to a Creditor to to Amount of Debt Satisfied.
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debt.
TRANSACTIONS THAT DECREASE
WORKING CAPITAL
S. No. Type of Example Working Capital Effect
Transactions
1. Current Assets to Purchase of Fixed Decrease in Cash Equal to Amount
Long-Term Assets Asset (e.g. Building) of Cash Actually Paid
2. Current Assets to Debentures Payable Decrease in Cash Equal to Amount
Long-Term Liabilities Paid from Cash to Reduce the Debt

3. Current Assets to Incurring a Net Loss Will Decrease Working Capital Only
Owner’s Equity from operating if Cash Paid for and Accruals of
Current Expenses Plus Current
Assets Consumed During the Year
Exceed Cash and Receivable
Derived from Revenues
4. Current Liabilities to Purchase of Fixed Increase in Creditors Equal to
Long-Term Assets Asset on Short-term Amount of Fixed Asset
Credit
5. Owner’s Equity to Declaration of Cash Increase of Current Liability as of
Current Liabilities Dividend the Date of declaration Equal to
Amount to be Paid
6. Long-Term Liabilities Current Maturities of Increase in Current Liabilities if the
to Current Liabilities Long-Term Debt
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from Working Capital
SOURCES AND USES OF CASH
APPROACH
There are changes in financial position that do not affect
funds flow, yet should be included in the funds flow
statement. If funds are defined as cash, the statement of
changes in financial position disclose individual sources and
use of cash. The analysis of cash flow is very similar to the
analysis which was described for the working capital
concept of funds. Additional adjustments, however, are
necessary to convert the net income for the period to the
amount of cash which was provided by operations.

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CASH FLOW FROM OPERATIONS
Several adjustments are required to convert a firm’s net
income to cash flow operations. A non-fund expenses, such
as depreciation, is an allocation of a past cost and thus
does not result in an outlay of cash during the current
period. Therefore, non fund expenses must be added back
to net income in determining cash provided by operations.

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COMPUTATION OF CASH FROM
OPERATIONS
Net income as per income statement (P&L A/c) ..………….
Add: Non–Fund Expenses
Depreciation …………….
Amortization/Write 0ff of Patents, preliminary
Expenses or Loss on sale of Fixed assets …………….
Deduct: Profit on sale of fixed assets .…………..
Net Working Capital or funds provided by operations (A) ……..
Add: Decrease in Current Assets …..……….
Increase in Current Liabilities ….………..
Deduct: Increase in Current Assets ....……….
Decrease in Current Liabilities ……………
Net Charge (B) ………
Cash Generated by operations (A) + (B) …..……..

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