What is Liquidity ratio and why is it important?
Investopedia defines Liquidity ratios as:
A class of financial metrics that is used to determine a company's ability to pay off its short-terms debts obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts.
Liquidity ratio is a metric or an indicator where one can see or gauge a company's ability to pay short term debts. It enables one to determine if the company can pay off maturing debts that supports its operations. Short term debts are incurred to fund current operations thus if the capability of a company to pay such is impaired, the company might have to stop its operation causing a delay in operation thus affecting its earnings.
Liquidity Ratios include the following:
1. Current Ratio - is derived by dividing current assets by current
liability. A number higher than one is a good
2. Quick Ratio - also known as acid test ratio is a
stricter/conservative way of determining liquidity
by taking out inventory in the current asset amount.
3. Operating Cashflow ratio - is derived by dividing cashflow from
operations by current liabilities.
With these ratios we can now determine if a company is liquid enough to pay off its outstanding or due debt. Determining if a company is liquid enables us to project if the company will continually generate earnings since it has enough fund to support its day to day operation without need of additional capital from investors or lenders.
It is a sign that a company manages its finances well by having enough liquid funds to avoid interest expense.
On the contrary there is a thinking that if a company has a good earnings and have a current ratio below one then it is able to leverage. This means that the company is earning on borrowed money. As long as it is able to meet its debt obligation on time without incurring additional finance cost then that is okay.