How to Figure Financial Liquidity
A business is considered to be liquid if it can cover current debt with current assets. In other words, can a company pay off its current liabilities without going to outside sources (such as a bank) to borrow money?
A common example of a current liability is accounts payable, which is money the company owes its vendors for goods and services it purchases during the normal course of business and anticipates paying back in the short term.
The ratio to figure financial liquidity is the current cash debt coverage ratio. The formula for this ratio is net cash provided by operating activities divided by average current liabilities. Using net cash provided by operating activities from the following figure, and assuming average current liabilities of $112,000, the ratio is 1.027, rounded ($115,000 @@ds $112,000).
Current debt coverage for this example is close to 1:1, which is generally considered good. Financiers agree this usually indicates that the company can pay current obligations without going to outside borrowing sources.
Anytime one of your intermediate accounting homework or exam questions asks for an average figure, you find the average by adding the beginning and ending balances together and dividing by 2. If accounts payable at January 1 is $215,000 and $175,000 at January 31, the average accounts payable is $195,000 ([$215,000 + $175,000] / 2).