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Types Of Liquidity

Types of Liquidity Assignment / Homework Help
Liquidity refers to the availability of cash and the capacity of a firm to convert its current assets into cash easily and immediately without significant loss. Any firm does not keep its entire available cash in the form of cash. The reason is that idle cash is not productive unless invested in an interest bearing security or deposits. But such deposits should be such that they can be converted into cash easily and immediately so that liquidity is maintained. The various types of liquidity methods are:

  • Cash Balance in account

    This is the highest form of liquidity but which earns no interest for the simple reason that it is not a deposit kept for a specific period. On an average, companies maintain at least five percent of their total assets as cash balance. But this percentage depends upon the nature of business. If the nature of business is cash oriented, some companies may even maintain up to twenty percent of their total assets as cash balance in account. Examples of such companies are trading and financial enterprises, whose business itself is dealing with cash. Manufacturing companies also require more cash especially if their operating cycle is more. Generally, service-oriented companies require fewer amounts of cash.
  • Overdraft arrangement with Banks

    This type of facility is available for businesses with current account. The amounts lying idle in current account do not earn any interest. Upon negotiation with the bank and depending upon the business credentials, “overdraft limit” is fixed by the banks. At any point of time, the business or company cannot borrow or make payment above the fixed limit. Moreover, the overdraft availed is repayable on demand by the bank. In some cases, depending upon the size of the overdraft facility, banks may require companies to keep a security against it.

    Advantages of overdraft arrangement:
    • The company has an immediate short-term financing facility without documentation and hassles
    • The company needs to pay interest only on the amount overdrawn. This is advantageous over loans because the entire amount of loan whether utilized or unutilized attracts interest
    • Bank is in a position to review periodically and adjust the overdraft limit from time to time. Thus it provides flexibility for the banks

    • Overdraft amounts are repayable on demand by the bank. Hence, the company cannot plan for definite using this facility. It is only a timely arrangement.
    • They cannot be considered a permanent source of finance
    • The interest levied on the overdrawn amount by the bank is higher than the normal base rate charged by the banks. Overdraft fees may also apply
    • Banks closely monitor the periodical budgets and performance to provide this facility

    Despite the above limitations, overdraft is widely used by companies as it ensures liquidity.
  • Marketable Securities

    Marketable securities are short-term investment instruments to obtain a return on temporarily idle funds. The basic characteristics of marketable securities affect the degree of their liquidity or marketability. To be liquid, a security must have two basic characteristics: a ready market and safety of principal. Ready marketability minimizes the amount of time required to convert a security into cash. The second determinant of liquidity is that there should be little or no loss in the value of marketable security overtime. Only those securities that can be easily converted into cash without any reduction in the principal amount qualify for short-term investments. So, they earn a lower return as the fear of losing the principal is very less. For selecting a proper marketable security, the financial manager should consider the following factors:

    • Financial/default risk
    • Interest rate risk
    • Taxability
    • Liquidity
    • Yield

    Treasury bills, units, bankers' acceptances etc., are common forms of marketable securities.
  • Factoring

    Factoring is a method of using receivables for financing. In this case, the accounts receivables serve as security for the financing made by the bank/factor. Factoring is the outright sale of accounts receivable to a bank or finance company without recourse. The advantages of factoring in this context are that it offers immediate cash and thus helps in liquidity and it allows for receipt of advances as required on a seasonal basis and it strengthens the company’s balance sheet position.
  • Inter-Company Deposits

    They are short-term deposits with other companies and are a fairly attractive form of investment of short-term funds in terms of rate of return. But these kinds of deposits generally require a month's time for conversion into cash and hence have to be planned in advance for meeting any short-term obligation.
  • Money Market Mutual Funds / Liquid funds

    Though these come under marketable securities, they can be considered and dealt with separately, being highly liquid. Money market mutual funds are professionally managed portfolios of marketable securities, which provide instant liquidity. These funds have achieved significant growth due to their competitive yields and high liquidity.

After considering all the significant factors for investment, a company may choose an appropriate liquidity mix.

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