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Understanding the Significance of Liquidity Ratios in Lending

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Synopsis:

Whether you are an investor, a lender, or a regulator, liquidity ratio is an extremely important indicator of a firm’s short-term financial health. It tells us whether a company can pay its short-term obligations in time, without putting too much financial pressure on itself. If a firm is unable to do so, then the lenders may not provide it with credit and even investors may ignore it. If a firm’s short-term liquidity is consistently under pressure, then even regulators may start suspecting that something is wrong with it.

Liquidity ratios are an extremely important measure in understanding a company's short-term liquidity. We calculate these ratios to check whether a company can pay off its short-term obligations, such as unpaid expenses and short-term debt, easily without putting a considerable strain on its resources. If a company is not able to do so, then a lender may either not lend to it or charge an excessively high rate of interest for providing funds. Read this blog, as it explains the meaning and types of liquidity ratios and other related aspects in great detail.

What Are Liquidity Ratios?

Liquidity ratios tell us how easily a firm can pay off its obligations, which are falling due in the short term. All firms have to pay their creditors and suppliers in a short period, usually less than one year. They also have to pay off their short-term debt, falling due within a year. To pay such obligations, firms need to convert their current assets, such as accounts receivables, inventory, cash equivalents, and marketable securities into cash within a year. Liquidity ratios measure how fast firms can use their current assets to pay off their short-term obligations. Having learnt what liquidity ratios are, let us delve deeper into this topic.

Types of Liquidity Ratios

Various types of liquidity ratios are considered by analysts and experts, prominent ones are explained below:

  1. Current Ratio: This is calculated by dividing a firm’s current assets by its current liabilities. Current assets include accounts receivables, stock, prepaid expenses, cash and bank balance, and marketable securities. Current liabilities include creditors, bank overdraft, outstanding expenses, short-term loans, etc.

  2. Quick Ratio: Quick ratio is more conservative than current ratio, as it does not include a few current assets included in the latter. To calculate this ratio, we do not include certain current assets that cannot be converted into cash easily, such as inventory and prepaid expenses. The formula for quick ratio is = (Cash + Assets like Cash + Debtors + Marketable Securities) / Current Liabilities.

  3. Absolute Liquidity Ratio: This ratio is even more conservative than quick ratio. To calculate it, under current assets, we include only assets such as cash and marketable securities because such assets can be readily converted into cash. The formula for absolute liquidity ratio is = (Cash + Marketable Securities) / Current Liabilities.

Formula of Liquidity Ratio   (need to add approx. 100 words content in a bullet format)

Importance of Liquidity Ratios

  • If a company’s lenders and creditors find out that it is not able to pay its short-term obligations easily, then they may not extend credit to it. Hence, it’s extremely important for lenders and creditors.

  • Investors consider liquidity ratios to assess a firm’s short-term financial health. If a company is not able to pay its short-term obligations in time, then its finances may come under from a long-term perspective as well. Hence, investors may ignore such a stock.

  • If regulators figure out that a company is not able to meet its short-term obligations regularly, then they may suspect that something is wrong with the company’s management, which may prompt them to take action.

Limitations of Liquidity Ratio   

The limitations of liquidity ratio are explained below in detail:

  • Liquidity ratio is static in nature. It is based on the data reported on a particular date. Hence, it does not consider the timings of cash flows and the dynamic nature of a business, which is its limitation.

  • If a company has a high liquidity ratio, it does not always mean that it is managed well. For example, it can hold a lot of cash, which can be deployed to earn a high return for shareholders. By holding cash, it is earning nothing and its liquidity ratio is high, but it is giving up the possibility of earning a high return for its shareholders. Hence, liquidity ratio alone does not tell much about the overall financial health of a firm.

Conclusion

Whether you are going to open a free or a regular demat account, liquidity ratio is an important metric for you to understand. It is not difficult to learn the meaning and types of liquidity ratios. However, the ideal liquidity ratio may vary from one sector to another. Besides, you may need your discretion to figure out which liquidity ratio to use in a certain situation. Hence, be careful while using the liquidity ratio.

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

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Frequently Asked Questions

What is the meaning of liquidity ratio?

Answer Field

Liquidity ratio examines how quickly and easily a firm can pay off its obligations arising within a year without straining itself financially.

Why is liquidity ratio important in financial analysis?

Answer Field

If a company is not able to maintain a decent liquidity ratio, it may not be able to pay its short-term obligations easily. This is not good from the viewpoints of investors, lenders, and even regulators. Hence, it is an extremely important metric to consider.

What are the different types of liquidity ratios?

Answer Field

Current Ratio, Quick Ratio, & Absolute Liquidity Ratio are the three prominent types of liquidity ratios.

Current Ratio = Current Assets / Current Liabilities

Quick Ratio = (Cash + Assets like Cash + Debtors + Marketable Securities) / Current Liabilities.

Absolute Liquidity Ratio = (Cash + Marketable Securities) / Current Liabilities.

 

How do you calculate the current ratio?

Answer Field

Current ratio is calculated by dividing a firm’s current assets by its current liabilities.

What is the quick ratio, and how is it different from the current ratio?

Answer Field

Quick ratio is a measure of a company’s short-term liquidity. It is a variation of current ratio. Under this ratio, we do not consider prepaid expenses and inventory while calculating current assets because they cannot be readily converted into cash.

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