Working capital is a term of liquidation as per the accountants. For them it is more important to ascertain if the company would be in a position to pay off its liabilities using its cash flows than to what level of current and non-current resources it holds. The disparity between current assets and current liabilities is therefore considered to be more important than the volume of the investment either in current assets or current liabilities. The success of the management of working capital ultimately depends on the optimal level of liquidity held by the organization. Higher level of liquidity has a bearing on the profitability of the firm whereas lower liquidity level can affect the operations of the firm. There are many factors that contribute to the changes in the level of liquidity but the changes in the composition of the working capital elements is probably the most significant among them all which leads to fluctuations in the cash flows. The fluctuations in the cash flows create uncertainty in the minds of the managers and prompt them to maintain higher levels of liquidity to tie over the difficult times.If cash flows were certain, less working capital would be required, usually, the problem stems from the difficulty in forecasting inflows, vis-à-vis outflows.
Concept of Liquidity
By the term ‘liquidity’ it is meant the debt-repaying capacity of an undertaking. It refers to the firm’s ability to meet the claims of suppliers of goods, services and capital. According to Archer and D’Ambrosio, liquidity means cash and cash availability, and it is from current operations and previous accumulations that cash is available, to take care of the claims of both the short-term suppliers of capital and the long-term ones. It has two dimensions; the short-term and the long-term liquidity. Short-term liquidity implies the capacity of the undertaking, to repay the short-term debt, which means the same as the ability of the firm in meeting the currently maturing obligations form out of the current assets. The purpose of the short-term analysis is to derive a picture of the capacity of the firm to meet its short-term obligations out of its short-term resources, that is, to estimate the risk of supplying short-term capital to the firm.
Analysis of the firm’s long-term position has for its rationale, the delineation of the ability of a firm to meet its long-term financial obligations such as interest and dividend payment and repayment of principal. Long-term liquidity refers to the ability of the firm to retire long-term debt and interest and other long-run obligations. When relationships are established along these lines, it is assumed that in the long-run assets could be liquidated to meet the financial claims of the firm. Quite often the expression ‘liquidity’ is used to mean short-term liquidity of the companies. In the present study, liquidity is taken to mean the short-term liquidity which refers to the ability of the undertakings to pay-of current liabilities. This is chosen because the study is related to the management of short-term assets and liabilities. Further, the concept of short-term liquidity is more suited to enterprises that have a remote possibility of becoming insolvent. In other words, the long-run success of an undertaking lies in its ability to survive in the immediate future. Further, a company may have tremendous potential for profitability in the long-run, but may languish due to inadequate liquidity. It is, therefore, short-term liquidity that has been considered crucial to the very existence of an enterprise.
Fundamentals of Liquidity
The measurement of liquidity was accomplished by comparing current assets with current liabilities. But, focus has not been thrown on the factors that determine liquidity. Several factors influence the liquidity position of an undertaking. Significant among them are:
- The nature and volume of business;
- The size and composition of current assets and current liabilities:
- The method of financing current assets;
- The level of investment in fixed assets in relation to the total long-term funds; and
- The control over current assets and current liabilities.
Firstly, the nature and volume of business influence the liquidity of an enterprise. Depending upon the nature of the units, some firms require more working capital than others. For some of the concerns like public utilities, less proportion of working capital is needed, vis-à-vis, manufacturing organizations. Besides, an increasing volume of business also enhances the funds needed to finance current assets. In these situations, if the firm does not divert some funds form the long-term sources, the liquidity ratios would be adversely affected.
Secondly, the size and the composition of current assets and current liabilities were the basic factors that determine the liquidity of an enterprise. If a higher investment is made in the current assets in relation to current liabilities, there would be a corresponding rise in the current ratio. While quickly and other ratios depend on the composition of current assets.
Thirdly, the method of financing current assets causes changes in the liquidity ratios. If greater part of the current assets are financed form long-term sources, greater also would be the current ratio. On the other hand, if the concern depends much on the outside sources for financing current assets, the ratio would fall.
Fourthly, the absorption of funds by fixed assets is one of the major causes of low liquidity. As more and more of the firm’s total funds are absorbed in this process, there will be little left to finance short-term needs and therefore liquidity ratios fall. Hence, the degree of liquidity is determined by the attitude of the management in the allocation of permanent funds between fixed and current assets.
Finally, stringent control over the current items causes fluctuations in the liquidity ratios. If investment in current assets is not taken care of properly, the firm may accumulate excess liquidity, which may adversely affect the profitability. On the contrary, unduly strict control of the investment in all types of current assets may eventually endanger the existence of the firm; owing to noncompliance of claims because of the shortage of funds. Similarly, control over current liabilities also plays an important role in determining liquidity of an enterprise by requiring the firm to contribute necessary funds from long-term sources to keep up the liquidity position.
Effects of Liquidity
Liquidity of a business is one of the key factors determining its propensity to succeed or fail. Both excess and shortage of liquidity affect the interests of the firm. By excess liquidity in a business enterprise, it is meant that it is carrying higher current assets than are warranted by the requirements of production. Hence, it indicates the blocking up of funds in current assets without any return. Besides, the firm has to incur costs to carry them overtime. Further, the value of such assets would depreciate in times of inflation, if they are left idle. Owing to the cornering of capital, the firm may have to resort to additional borrowing even at a fancy price.
On the other hand, the impact of inadequate liquidity is more severe. The losses due to insufficient liquidity would be many. Production may have to be curtailed or stopped for want of necessary funds. As the firm will not be in a position to pay- off the debts, the credit worthiness of the firm is badly affected. In general, the smaller the amount of default, the higher would be the damage done to the image of the unit. In addition, the firm will not be able to secure funds from outside sources, and the existing creditors may even force the firm into bankruptcy. Further, insufficient funds will not allow the concern to launch any profitable project or earn attractive rates of return on existing investment.
Between the excess and inadequate liquidity, the latter is considered to be more detrimental, since the lack of liquidity may endanger the very existence of the business enterprise. Besides, both the excess and inadequate liquidity adversely affect the profitability. If the firm is earning very low rates of return or incurring losses, there would be no funds generated by the operations of the company, which are essential to retire the debts. In fact, there is a tangle between liquidity and profitability, which eventually determines the optimum level of investment in current assets. Of the liquidity and profitability, the former assumes further importance since profits could be earned with ease in subsequent periods, once the image of the unit is maintained.