What Is High Liquidity?
A company's liquidity indicates its ability to pay debt obligations, or current liabilities, without having to raise external capital or take out loans. High liquidity means that a company can easily meet its short-term debts while low liquidity implies the opposite and that a company could imminently face bankruptcy.
Key Takeaways:
- Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital.
- Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding.
- Liquidity ratios determine a company's ability to cover short-term obligations and cash flows, while solvency ratios are concerned with a longer-term ability to pay ongoing debts.
Understanding High Liquidity
If a company has plenty of cash or liquid assets on hand and can easily pay any debts that may come due in the short term, that is an indicator of high liquidity and financial health. However, it could also be an indicator that a company is not investing sufficiently.
To calculate liquidity, current liabilitiesare analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency. Liquidity is typically measured using thecurrent ratio,quick ratio, andoperating cash flow ratio. While in certain scenarios, a high liquidity value may be key, it is not always important for a company to have a high liquidity ratio. The basic function of the liquidity ratio is to measure a company’s capability to settle all current debt with all current available assets. The stability and financial health, or lack thereof, of a company and its efficiency in paying off debt is of great importance to market analysts, creditors, and potential investors.
Why a High Liquidity Ratio Is Not Essential
The lower the liquidity ratio, the greater the chance the company is, or may soon be, suffering financial difficulty. Still, a high liquidity rate is not necessarily a good thing. A high value resulting from the liquidity ratio may be a sign the company is overly focused on liquidity, which can be detrimental to the effective use of capital and business expansion. A company may have an impressive (high) liquidity ratio but, precisely because of its high liquidity, it may present an unfavorable picture to analysts and investors who will also consider other measures of a company's performance such as the profitability ratios of return on capital employed (ROCE) or return on equity (ROE). ROCE is a measurement of company performance with regard to how efficient a company is at making use of available capital to generate maximum profits. A formula calculates capital used in relation to net profit generated.
Special Considerations
Ultimately, every company's owners or executives need to make decisions regarding liquidity that are tailored to their specific companies. There are a number of tools, metrics, and standards by which profitability, efficiency, and the value of a company are measured. It is important for investors and analysts to evaluate a company from several different perspectives to obtain an accurate overall assessment of a company's current value and future potential.
FAQs
Another advantage of liquidity ratios is their utility in assessing a company's financial health and risk level. A high liquidity ratio suggests that a company possesses sufficient liquid assets to handle its short-term obligations comfortably. A low liquidity ratio may signal potential liquidity issues.
Should companies always have high liquidity? ›
While in certain scenarios, a high liquidity value may be key, it is not always important for a company to have a high liquidity ratio. The basic function of the liquidity ratio is to measure a company's capability to settle all current debt with all current available assets.
Is it always good when liquidity is very high and continues growing? ›
Understanding Liquidity Ratios
A low liquidity ratio could signal a company is suffering from financial trouble. However, a very high liquidity ratio may be an indication that the company is too focused on liquidity to the detriment of efficiently utilizing capital to grow and expand its business.
Why is it important to have a high liquidity ratio? ›
Liquidity ratios are important to investors and creditors to determine if a company can cover their short-term obligations, and to what degree. A ratio of 1 is better than a ratio of less than 1, but it isn't ideal. Creditors and investors like to see higher liquidity ratios, such as 2 or 3.
What happens if liquidity is too high? ›
But it's also important to remember that if your liquidity ratio is too high, it may indicate that you're keeping too much cash on hand and aren't allocating your capital effectively. Instead, you could use that cash to fund growth initiatives or investments, which will be more profitable in the long run.
Is it better to have high liquidity? ›
The main advantage of strong liquidity is knowing there are enough assets to cover unexpected emergencies, changes in demand and surprise expenses. It can also improve a business's credit score which will give you a greater chance of securing funding should you need it.
Is liquidity good or bad? ›
Is Market Liquidity Good or Bad? There's only upside to market liquidity. In fact, the financial markets need liquidity to ensure that traders can open and close their positions efficiently and enjoy tighter bid-ask spreads. To put it simply, market liquidity actually lowers the cost of investing.
Is a high liquidity ratio good or bad? ›
Generally speaking, creditors and investors will look for an accounting liquidity ratio of around 2 or 3. A higher liquidity ratio means that your business has a more significant margin of safety with regard to your ability to pay off debt obligations.
Are high liquidity stocks good or bad? ›
Is a higher liquidity better? Generally, yes, a higher liquidity is better for investors, as it can signal that a company is performing well, and that its stock is in demand. It can also be easier for an investor to sell that stock in exchange for cash.
Why is it important for people to have enough liquidity? ›
We all have bills to pay, and having liquidity helps us to meet everyday cash needs and short-term financial obligations – whether we're talking about groceries, car payments, rent or mortgage. Emergency preparedness.
Extra cash may also lead to frivolous spending simply because the funds are available. If you're wondering, "How much cash should I have on hand?" it can be helpful to turn to that three- to sixth-month reserves figure. Any less and the business may be at risk of not meeting its obligations if sales were to drop.
What are the benefits of liquidity? ›
Liquid assets can be quickly and easily changed into currency. Healthy liquidity will help your company overcome financial challenges, secure loans and plan for your financial future.
Why is liquidity bad? ›
If a company has poor liquidity levels, it can indicate that the company will have trouble growing due to lack of short-term funds and that it may not generate enough profits to its current obligations.
Why is liquidity a problem? ›
A liquidity crisis occurs when a company can no longer finance its current liabilities from its available cash. For example, it is no longer able to pay its bills on time and therefore defaults on payments. In order to avoid insolvency, it must be able to obtain cash as quickly as possible in such a case.
Why is too much liquidity not good for the company? ›
It can also be a hurdle for business expansion. Excess liquidity suggests to investors, shareholders, and analysts that the firm is unable to effectively utilise the available cash resources or identify investment opportunities that can generate revenues.
Is liquidity important for a company? ›
Liquidity provides financial flexibility. Having enough cash or easily tradable assets allows individuals and companies to respond quickly to unexpected expenses, emergencies or business opportunities. It allows them to balance their finances without being forced to sell long-term assets on unfavourable terms.
