"Never spend money before you have it."
- Thomas Jefferson (1743 – 1826), American Founding Father and 3rd President of the USA

Liquidity means the extent to which an organization is able to convert its assets (items of monetary value owned by the business) into cash. Liquid assets are those that can be converted into cash quickly and without negatively impacting its market value. Examples of liquid assets include:

• Cash (including deposits at a commercial bank)

• Debtors

• Stock (inventory).

By contrast, illiquid assets are items of monetary value owned by a business that cannot be converted into cash as easily or quickly. Examples of illiquid assets include:

• Property

• Plant (production facilities)

• Equipment.

The liquidity position of an organization indicates the extent to which it has sufficient liquidity to continue its business activities. Being in a good liquidity position means the business can avoid bankruptcy (business closure) as the organization has sufficient liquidity to continue operating. A business in a poor liquidity position may struggle to cover its current liabilities. If the business is not able to improve its liquidity position, this can eventually lead to bankruptcy.

The liquidity position of a business is important as it shows its ability to repay short-term liabilities without having to rely on external sources of finance, which could dilute ownership and control and/or incur debt interest payments. The main method of measuring a firm's liquidity position is liquidity ratio analysis.

Liquidity ratios are financial ratios that examine an organization’s ability to pay its short-term liabilities and debts. The IB Business Management syllabus specifies the following two liquidity ratios:

• Current ratio

• Acid test ratio (also known as the quick ratio).

The current ratio is a short-term liquidity ratio used to calculate the ability of an organization to meet its short-term debts (within the next twelve months of the balance sheet date). It calculates the value of an organization’s liquid assets relative to its short-term liabilities. In general, the minimum figure for the current ratio for any firm must be 1.0 (or 1:1). What this means is that the firm has just enough liquid assets to pay off its short-term liabilities.

The acid test ratio (also known as the quick ratio) is a short-term liquidity ratio used to measure an organization’s ability to pay its short-term debts (within the next twelve months of the balance sheet date), without the need to sell any stock (inventories). Stocks are ignored from the calculation as some inventories are not highly liquid, such as work-in-progress or very expensive finished goods sold in niche markets. This makes the stock difficult to sell or convert into cash in a short period of time. It is usual to expect as a bare minimum that firms have an acid test ratio of no less than 1:1, otherwise it would mean that the business has a serious liquidity problem.

These liquidity ratios are used to measure the extent to which an organization can pay off its short-term debts using its current (liquid) assets. It is vital for all businesses to manage their liquidity position in order to prevent a liquidity crisis (the situation that arises when the organization is unable to pay its short-term debts). In the worst-case scenario, a liquidity crisis could lead to insolvency, i.e., bankruptcy of the business.

• Liquidity means the extent to which an organization is able to convert its assets into cash.

• A liquidity crisis is a situation that arises when a business is unable to pay its short-term debts. This can eventually lead to bankruptcy.

• An organization's liquidity position refers to the extent to which it has sufficient liquidity in order to continue its business operations.

• A liquidity problem (or cash flow problem) occurs when there is a lack of cash in the organization because its cash inflows are less than its cash outflows, i.e., it experiences negative net cash flow.