Single Period Dividend Discount Model
To understand the dividend discount model, we need to start from the basics. The simplest way to understand the dividend discount model and its application is to first start with a single period and then later extend it on to more complex cases. Hence, the term single period dividend discount model. The objective of application […]
Advantages of Behavioral Finance
The problem with traditional financial theories is that they tend to operate in an ideal world! The underlying assumptions are that the information available is perfect, the investors are capable of interpreting the information. Another assumption is that there is a single right answer which can be mathematically worked out. However, when investors use this […]
Pros and Cons of Convertible Notes
In the previous article, we studied what convertible notes are and how they are used in the context of financing a startup firm. The various terms and conditions which are generally a part of the convertible notes agreement were also explained along with the working of the note. However, before investors and founders make a […]
Primary Markets vs. Secondary Markets
The buying and selling of financial securities is a complex process that has evolved over many years. Each security represents a claim on the financial resources of a firm. The claim could be an equity claim or a debt-related claim. When a retail investor looks at the stock market, they see only the market where […]
Usage of Collateralized Debt Obligations (CDO) in Infrastructure Finance
Infrastructure finance is an extremely complicated and advanced field. There are many complex financial instruments related to infrastructure finance which have been created and are regularly traded between interested parties. One such financial instrument is the collateralized debt obligation (CDOs). The issuance of CDOs is the most basic way in which the principles of structured […]
Liquidity can be defined as the ability of a firm to make good its short term obligations. Most businesses function on credit. Hence to run a business firms have to both extend credit as well as ensure that they receive credit as well.
Liquidity ratios measure the relationship between the amounts of short term capital that the firm has locked in its receivables versus the short term interest free debt it has acquired in the form of accounts payables.
Liquidity ratios can be defined as the ratios which help analysts predict the short term solvency of the firm. Short term here is meant to be considered the period until the next business cycle which is usually 12 months.
A firm seldom has all the resources it needs to run the business. It gets credit from its employees, suppliers, customers, the government and such other entities. Each of these entities extends credit to the firm on the assumption that it will make good its obligations when they are due. Such obligations are usually due in the short term.
Investors are therefore very cautious about ascertaining whether the firm does in fact have the capability to meet these obligations. Liquidity ratios help in ascertaining this. With secondary data that is available in the annual reports of the company, analysts often make projections about whether the company has enough resources to survive the short run without hampering its reputation or operations.
Amateur investors think liquidity is primarily short term. It does not matter whether or not the company can pay its immediate bills, if the long term prospects of the company look good, it is a good investment. This is the farthest from the truth as history has shown liquidity issues can have far reaching effects on the health of a firm sometimes even endangering the very survival of the firm. Here is how it happens:
As a result of all these, present profitability is compromised and so are the future growth plans of the company which now has to seek funds at extremely high costs.
The best example of how liquidity problems can wreak havoc and threaten the very survival of a firm is the recent Kingfisher Airlines fiasco where the firm had to shut down operations because it could not meet its short term obligations.
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