Current Financial Position
The shareholders, managers and creditors scrutinize the balance sheet of the company to gauge the firms' financial condition as revealed by its networking capital. Adequate working capital is required to enable the company to carry out the business smoothly and comfortably. Inadequate working capital may lead to delay in settling obligations as and when they arise, prevent the firm from taking advantage of opportunities and may in extreme cases lead to insolvency and winding up of the firm. A company is considered to be financially sound, if it can carry on its business smoothly and meet all its obligations. The study and interpretation of current financial position involves the study of individual items of the current assets, current liabilities and net working capital and their relationships in the form of ratios. These ratios are often referred to as liquidity ratios or short-term ratios.
Importance of Short-term Liquidity/Solvency
A company's short-term liquidity refers to the ability to convert assets into cash or to obtain cash. Lack of liquidity in the company indicates the company's inability to take advantage of the economies of scale like discounts on bulk purchases etc. It also limits the actions of management i.e., managers may restrict themselves for taking the opportunities. In extreme cases, companies may sell their investments and assets to meet the short-term obligations.
Lack of short-term liquidity leads to lower profits and fewer opportunities. It foretells the investor about the loss of capital investment. In case of non-corporate entities, this problem leads to the loss of their personal assets. Creditors may suffer from delayed payments of interest and principal amounts or they may lose their amounts due to company. This problem also affects the relationship with customers. Lack of liquidity may cause the non-execution of contracts with customers and non-payment of damages to customers.
The following are the important liquidity ratios, which indicate the short-term solvency of a firm.
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