5.

(a)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 acid-test ratio, net working capital to determine the liquidity of the
firm.

(b)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.

(c)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