XSIQ
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Accounting - Liquidity ratios
Liquidity ratios
There is an optimum amount for working capital and it may be too high or
too low. A working capital (WC) that is too high means an inefficient use
of funds, reflected by excessive stock, debtors or cash. It may also
indicate an inability to obtain stock on credit.
A WC that is too low means the inability to take advantage of credit terms
offered with the loss of discount. Businesses are engaged in 'hand to
mouth' buying and may be forced to rely on bank overdrafts and other
credit, which is expensive.
This ratio is easily manipulated. For instance, borrowing long term to
repay short term debts will improve the ratio without being of benefit to
the business.
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What is the practical relevance of liquidity ratio in an inflationary economy?
I quite agree that the liquidity ratio can be easily manipulated by borrowing long term to pay short term debts. However,the fundamental issue is the cost of capital. If the long term cost of capital is cheaper than the short term debt cost of capital it may be beneficial to the business in the long run.
The current liabilities are business financial commitments which fall due within a business financial year. The examples are :Bank loans (which fall due within one accounting period), Trade creditors and so on.