The liquidity index is a financial indicator that is used to indicate the number of days required by a company to convert its trade receivables and inventory into cash. The liquidity index is the measure of the ability of a business to generate cash when it is required to fulfill the current liabilities of the business. There are several steps that must be taken to calculate the liquidity index of a business. These steps can be described as follows
- In the first step the average collection period is multiplied by the ending trade receivables
- In the next step the average inventory liquidation period is multiplied by the ending inventory balance
- Add the resultant figures that comes from the above mentioned calculation and divide the figure with trade receivable and inventory balance
The formula of the liquidity index can be shown as under:-
(Trade Receivable x Days to liquidate) + (Inventory x Days to liquidate)/ Trade Receivable +Inventory
The liquidation days count is taken from the historical data of the business or firm. Sometimes the historical average cannot be translated well into trade receivable and inventory at hand that may result in variation in the actual cash flows. Another thing that must be kept in mind while calculating and implementing liquidity index is that if the information is being plotted on the trend line the same averaging method must be applied to all of the accounting period.