5 a.

What procedure would you adopt to study the liquidity of a business

firm?
Liquidity is the ability of the firm to convert assets into cash. It is also called
marketability or short-term solvency. In other words, it is the ability of the firm to
meet its day-to-day obligations.
In order to study the liquidity of the firm, we need to thoroughly examine its asset
structure, mainly the current assets. The current assets, viz: stock, debtors, bank
balance and other current assets need to be seen to determine at what rate a firm
can convert these into cash. A business that collects its accounts receivable in an
average of 20 days generally has more cash on hand than a business that requires
45 days. Similarly, a business that turns over its inventory 15 times a year has more
cash on hand than a company that turns its inventory only 10 times a year. A
business which keeps surplus cash or an idle bank balance may be readily able to
meet its short-term or daily obligations but it is not effectively utilizing its cash
flow.
Another factor to determine the liquidity is to see the profitability of the firm. The
more profitable the firm is, the more cash resources it shall have. Last, but not the
least, we use make use of certain financial ratios like current ratio, quick or acidtest ratio, net working capital to determine the liquidity of the firm.

5 b: Who are all the parties interested in knowing this accounting

information?
The various parties interested in determining the liquidity of the firm would
be the business owners and managers, bankers, investors, creditors and financial
analysts.
Business owners and managers use ratios to chart a company's progress, uncover
trends and point to potential problem areas in a business. One can also use ratios to
compare your company's performance with others within the industry.
Bankers and investors look at a company's ratios when they are trying to decide if
they want to lend you money or invest in your company. Creditors are interested in
the companys short-term and long-term ability to pay its debts.

Financial analysts, who frequently specialize in following certain industries,

routinely assess the profitability, liquidity, and solvency of companies in order to
make recommendations about the purchase or sale of securities, such as stocks and
bonds.
Question 5c: What ratio or other financial statement analysis technique will
you adopt for this.
The relevant ratios used to assess the liquidity of the firm are current ratio,
quick or acid test ratio, cash ratio and net working capital.
Current Ratio
Provides an indication of the liquidity of the business by comparing the amount of
current assets to current liabilities. A business's current assets generally consist of
cash, marketable securities, accounts receivable, and inventories. Current liabilities
include accounts payable, current maturities of long-term debt, accrued income
taxes, and other accrued expenses that are due within one year. In general,
businesses prefer to have at least one dollar of current assets for every dollar of
current liabilities. However, the normal current ratio fluctuates from industry to
industry. A current ratio significantly higher than the industry average could
indicate the existence of redundant assets. Conversely, a current ratio significantly
lower than the industry average could indicate a lack of liquidity.
Formula
Current Assets /Current Liabilities
Acid Test or Quick Ratio
A measurement of the liquidity position of the business. The quick ratio compares
the cash plus cash equivalents and accounts receivable to the current liabilities. The
primary difference between the current ratio and the quick ratio is the quick ratio
does not include inventory and prepaid expenses in the calculation. Consequently,
a business's quick ratio will be lower than its current ratio. It is a stringent test of
liquidity.
Formula
Cash + Marketable Securities + Accounts Receivable / (Current Liabilities)

Cash Ratio
Indicates a conservative view of liquidity such as when a company has pledged its
receivables and its inventory, or the analyst suspects severe liquidity problems with
inventory and receivables.
Formula
Cash Equivalents + Marketable Securities /(Current Liabilities)
Working capital
Working Capital compares current assets to current liabilities, and serves as the
liquid reserve available to satisfy contingencies and uncertainties. A high working
capital balance is mandated if the entity is unable to borrow on short notice. The
ratio indicates the short-term solvency of a business and in determining if a firm
can pay its current liabilities when due.
Formula
Current Assets - Current Liabilities