Liquidity Ratio

The liquidity ratio is the ratio between the overall liquid Assets of the company and the liabilities of the bank or other institutions which is related to the company. A liquidity ratio is an essential sector of any financial matter which is also used to determine the debtor’s ability to pay off any debt obligations without raising any external capital of the company. It measures any company’s ability to pay off the debt and the margin of safety through the calculation of proper metrics which includes quick ratio, current ratio, and operating cash flow ratio.

Liquidity Ratio Formula

The liquidity ratio is the ability to convert any assets of the company into cash in a very cheap manner and quick way. These liquidity ratios are very useful for the company as they are used in a very comparative form. This sort of analysis of the ratios can be very much external or internal.

The Formula for Liquidity Ratios are as follows:

Current ratio = Current Assets/current liabilities

Quick ratio = ( Current assets –inventory – prepaid expenses )/ Current liabilities 

                                                              or 

= (Cash and Cash Equivalents +marketable securities+ accounts receivable) /  Current Liabilities

Day Sales Outstanding = average accounts receivable / revenue per day 

A liquidity crisis can also arise in a situation when good companies have difficult circumstances around them in paying off their loans or paying the employees. In that situation, this is called a liquidity crisis. Normally every liquidity ratio mentioned here covers the ability of any firm in paying off the short-term obligations by dividing its current assets and current liabilities. On the other hand, the cash ratio only looks upon the cash in hand which is divided by the current liabilities of the company. 

Importance of Liquidity Ratio

The liquidity ratios are very important for the company because it determines the ability of the company to cover its short-term obligations. The creditors and investors in the company like to see the higher liquidity ratios which would be nearly two or three. The higher the ratio of liquidity the more likely a company can pay off its short-term bills. The creditors generally analyze the liquidity ratio when they are deciding whether they would extend the credit to the company or not. The creditors generally want to be sure that the company can pay back the money which they are lending to them. Any hint of any financial instability for the company may disqualify the company from obtaining loans from the market. And the liquidity ratio also determines the investment worthiness of the company. Investors gradually will analyze a company by using its liquidity ratio to ensure that the company is financially worthy and healthy for doing any sort of investment. The liquidity ratio to some extent will determine the profit or loss of the investors who were investing in the company.

Statutory Liquidity Ratio

The statutory liquidity ratio is the least amount of wealth a banking organization maintains as deposits in the form of gold, liquid cash, or all kinds of securities. It is generally the type of reservation prerequisite that all banks are normally needed to maintain before giving credits to the clientele. There is no reservation by the Reserve Bank of India but the statutory liquidity ratio is standardized by them. This ratio has been a traditional tool for any Central Bank policy for controlling the growth of credit or the incoming liquidity and inflation rate across the economy. The government gradually uses the statutory liquidity ratio for the regulation of liquidity and inflation. Increasing the statutory liquidity ratio will also control the inflation across the economy, which will decrease the cause of growth in the economy. The statutory liquidity ratio is a monetary policy of the Reserve Bank, but it is also essential for the government to have proper management of indebtedness.

Conclusion

It is seen through the ratio analysis that the liquidity ratio gradually indicates that the company or the business is holding a lot of cash which would generally be utilized in various areas for the betterment of the company. A low liquidity ratio will eventually mean that the form is struggling to pay off the short-term obligations and it is also known that if there is a liquidity ratio under 1 then the company is going through a liquidity crisis. These accounting ratios are very helpful for the proper analysis of the company’s performance and it also helps to calculate the balance sheet of the company on a specific date.