Liquidity Ratios & Stagnant Assets

Is it always a good idea to increase your company's liquidity ratio? Does a greater liquidity ratio signal sounder money management? When comparing two different firms in a lighthearted conversation with some friends, I was struck by how much emphasis they placed on their liquidity ratios. They often support a greater liquidity ratio as the single best indicator of sound financial management. Let's take a look and see whether this is a reasonable conclusion.

What is the liquidity ratio, to start with? The liquidity ratio is one of the financial measures used to assess a certain organization's financial health. Liquidity ratio is a collective term for several ratios, not just one. The terms "Current Ratio," "Quick Ratio," and "Cash Ratio" refer to three different liquidity ratios. They all take into account the business's capacity to pay its debts.

These ratios can be calculated using the following formula:

Current Ratio = (Current Assets) / (Current Liabilities)

Quick Ratio = (Current Assets - Inventory) / (Current Liabilities)

Cash Ratio = (Cash & Cash Equivalent) / (Current Liabilities)

All the measures mentioned above use a different approach to measuring liquidity ratios. They span the spectrum from an expansive view (like the Current Ratio) to a narrow and focused perspective (as in the Cash Ratio). To keep things simple, I'll simply use the current Ratio in the conversation that follows.

By dividing the current assets value of the corporation by the current liabilities value, we arrive at the "Current Ratio". It is a straightforward ratio that analysts and prospective investors use to assess the stability and financial health of the firm under analysis. It establishes how the business can pay off all of its responsibilities and debts. It shows the size of an organization's assets compared to its liabilities. According to the same logic, a low liquidity ratio may indicate that a corporation experiencing financial difficulties.

Quickly improve a company's liquidity ratio by using sweep accounts that transfer funds into higher interest rate accounts when they're not needed and back to readily accessible accounts when necessary. Paying down debts is another strategy to increase a company's liquidity ratio. This will lower the formula's denominator (see above). The liquidity ratio will rise as a consequence. Another strategy to raise the liquidity ratio is reducing short-term overhead costs.

It is clear from the previous section that the liquidity ratio is one of the critical metrics to assess its financial health. But what ratios are regarded as high and low, respectively? Sadly, there isn't a standard measurement for how high and how low to go. This depends on the industry and market the firm is operating?in. It also relies on how well the business can pay off its debts. A significant liability in one firm could be negligible in another. These variations across businesses, marketplaces, and sectors greatly influence whether specific values are seen as high or low. Even yet, the liquidity ratio is still seen as a significant indication, particularly when a corporation tracks its liquidity ratios over a long period.

What is high and low in terms of the liquidity ratio may be a key factor for investors when deciding whether to invest in a firm. Some investors, nevertheless, fail to consider the company's large current assets relative to liabilities. Here, I'm referring to the excessive liquidity ratio.

A very high liquidity ratio may show an excessive emphasis on increasing liquidity. If we apply a positive interpretation, a very high liquidity ratio can signify that the business is getting ready for costly growth. In such a scenario, the business will be well-equipped to finance its development independently or have a solid financial history with banks to get extra funding. But consider it from a different angle. What if there is no specific growth strategy and the firm has a very high liquidity ratio? This may be a risky sign that the firm has much liquidity that isn't being used, indicating weak financial soundness.

According to the Ready Ratios website, the average current Ratio of U.S. listed oil and gas businesses varies from 2.64 to 4.48 for the years 2015 through 2020. These percentages are considered excessive, but they may be justified given that the oil and gas sectors always have growth plans and incur extremely large exploration expenses, which the firms must be ready for at all times.

Contrarily, typical current ratios for the same period of 2015 to 2020 range from 289.28 to 3478.82 for security and commodities brokers, dealers, and exchange services businesses registered in the United States. This definitely points to possible underutilized money that is available for investment. These are general indications that vary from business to business. It prompts us to take a closer look.

I must acknowledge that a value of 1 is what practically all creditors use to grant credit to a corporation when discussing the value of the acceptable liquidity ratio. In actual use, it practically serves as a general principle. This does not invalidate anything I said before. Deeper analysts often take into account the liquidity ratio market standard.

On the other hand, a very high liquidity ratio is superior to a low liquidity ratio on all criteria. The large liquidity at least might be quickly used to settle short- and long-term debts, start a new expansion, or launch a new investment initiative. Flexibility is something that all businesses appreciate.

Consequently, I'm attempting to illustrate that even if the liquidity ratio is a crucial statistic to consider before investing in or appraising a firm, a high ratio does not necessarily imply strong financial health. It might conceal a significant flaw. The liquidity ratio must be compared to other data, including the company's short-term growth goals and the industry standard for liquidity ratios.

It's usually a good idea to work toward keeping a company's strong capacity to pay down its debts. However, this shouldn't go too far and cause the organization to be left with significant cash that is either unutilized or unplanned investments. Especially in areas with intense competition, the unutilized money represents a lost opportunity.