The Measurement of Liquidity

Abstract

Liquidity measurement is an integral part of financial statement analysis, particularly in credit evaluations, and liquidity ratios are frequently employed in empirical research in accounting. Interest in this topic has increased recently because of the changes and potential changes in financial reporting requirements. The Securities and Exchange Commission now requires that each firm's annual report and 10-K include a discussion of its liquidity position, while the Financial Accounting Standards Board (FASB) has published a discussion memorandum entitled Reporting Funds Flows, Liquidity, and Financial Flexibility. One issue raised by this discussion memorandum is Should summary indicators of liquidity be provided (in financial reports)? Please specify the most useful summary indicators, giving reasons for your choice. (See FASB [1980].) There is disagreement about what constitutes a good summary indicator or measure of liquidity. Several researchers have proposed liquidity measures that incorporate cash flows in response to criticisms of the static nature of balance sheet ratios. While their proposed measures are intuitively appealing, there is rarely either a theoretical or empirical basis for preferring one over any others. In those instances wherein measures with a theoretical basis are proposed, their implementation is severely hampered by restrictive assumptions regarding when they may be applied. The purpose of this paper is to propose liquidity measures that are not subject to these limitations. We employ an axiomatic description of a firm's liquidity policy and liquidity position to obtain an expression for the likelihood that the firm will exhaust its liquid reserves (become technically insolvent). This expression may be used directly to assess