Types of Liquidity
Liquidity refers to the accessibility of cash and the capacity of a company to convert its current assets into cash easily and at once without significant loss. Any company does not keep its entire accessible cash in the form of cash. The grounding that idle cash is not productive unless invested in an interest bearing security or deposits. But these type of deposits should be such that they can be changed over into cash easily and immediately hence that liquidity is conserved. The several types of liquidity methods are:
i) Cash Balance in Account
This is the highest form of liquidity but which earns no interest for the simple ground that it is not a deposit kept for a specific period. On an average, companies keep at least five percent of their total assets as cash balance. But sometimes it depends upon the nature of business. If the nature of business is cash oriented, some companies may even keep up to twenty percent of their total assets as cash balance in account. instances of such companies are trading and financial enterprises, whose business itself is addressing with cash. Manufacturing companies also require more cash particularly if their operating cycle is more. In general, service oriented companies require fewer amounts of cash.
b) Overdraft System with Banks
This type of facility is accessible for businesses with current account. The amounts lying idle in current account do not bring in any interest. Upon negotiation with the bank and based upon the business credentials, "overdraft limit" is fixed by the banks. At any point of time, the company cannot borrow or make payment above the fixed limit. In addition, the overdraft be useful to is repayable on demand by the bank. In few cases, based upon the size of the overdraft facility, banks may require companies to keep a security against it.
Rewards of overdraft system:
The company has an prompt short term financing facility without documentation and disturbance.
The company requires to pay interest only on the amount overdrawn. This is rewardful over loans since the entire amount of loan whether utilized or unfertilized attracts interest
Bank is in a position to examine again periodically and place in a line the overdraft limit from time to time. Thus it offers flexibility for the banks
Dis-rewards of overdraft system:
Overdraft amounts are repayable on demand by the bank. Hence, the company cannot plan for certain using this facility. It is only a timely arrangement.
They cannot be looked at a permanent source of finance
The interest levied on the overdrawn amount by the bank is higher than the normal base rate billed by the banks. Overdraft fees may also apply
Banks closely monitor the periodical budgets and performance to render this facility
Despite the above limitations, overdraft is widely utilized by companies as it ensures liquidity.
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