What is a good level of liquidity?
In short, a “good” liquidity ratio is anything higher than 1. Having said that, a liquidity ratio of 1 is unlikely to prove that your business is worthy of investment. Generally speaking, creditors and investors will look for an accounting liquidity ratio of around 2 or 3.
When analyzing a company, investors and creditors want to see a company with liquidity ratios above 1.0. A company with healthy liquidity ratios is more likely to be approved for credit.
For example, if a company has a current ratio of 1.5—meaning its current assets exceed its current liabilities by 50%—it is in a relatively good position to pay off short-term debt obligations. Conversely, if the company's ratio is 0.8 or less, it may not have enough liquidity to pay off its short-term obligations.
A current ratio below 1 means that the company doesn't have enough liquid assets to cover its short-term liabilities. A ratio of 1:1 indicates that current assets are equal to current liabilities and that the business is just able to cover all of its short-term obligations.
A higher overall liquidity ratio indicates the company has more liquid current assets to cover its short-term liabilities and expenses. An overall liquidity ratio of 1.5 or higher is considered financially healthy. For example, if a company has: Total current assets of $2,000,000.
A liquidity ratio is important because it states how much cash a bank to meet the request of its depositors. Therefore, a bank with a liquidity ratio of less than 30% is not a good sign and may be in bad financial health. Above 30% is a good sign.
Excess liquidity is the money in the banking system that is left over after commercial banks have met specific requirements to hold minimum levels of reserves. Banks must hold these minimum reserves to cover certain liabilities, mainly customer deposits.
Generally speaking, a good quick ratio is anything above 1 or 1:1. A ratio of 1:1 would mean the company has the same amount of liquid assets as current liabilities. A higher ratio indicates the company could pay off current liabilities several times over.
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.
| Liquidity Ratios | Formula |
|---|---|
| Current Ratio | Current Assets / Current Liabilities |
| Quick Ratio | (Cash + Marketable securities + Accounts receivable) / Current liabilities |
| Cash Ratio | Cash and equivalent / Current liabilities |
| Net Working Capital Ratio | Current Assets – Current Liabilities |
What does a liquidity ratio of 2.5 mean?
The current ratio for Company ABC is 2.5, which means that it has 2.5 times its liabilities in assets and can currently meet its financial obligations Any current ratio over 2 is considered 'good' by most accounts.
A healthy current ratio ranges from 2 to 2.5. This means that the company's current assets level is 2 to 2.5 times higher than its current liabilities level. A lower current ratio may indicate that the firm doesn't have sufficient assets to pay for its liabilities.
This ratio focuses primarily on the organization's ability to service debt payments in the near future. A ratio of 1.2 specifically indicates that the organization has $1.20 in liquid assets for every $1.00 of debt requirements.
- Current Ratio = Current Assets / Current Liabilities.
- Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivable) / Current Liabilities.
- Cash Ratio = (Cash and Cash Equivalents + Short-Term Investments) / Current Liabilities.
A low liquidity ratio, such as 0.5, indicates that a company does not have enough current assets to cover their current liabilities. If these current liabilities needed to be paid sooner than expected, the company would not be able to afford.
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.
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.
| Bank | Cash as % of Assets | AFS Unrealized Bond Losses on Dec. 31, 2022 |
|---|---|---|
| SVB Financial | 6.5% | $2.5 billion |
| JPMorgan Chase | 15.5% | $11.2 billion |
| Bank of America | 7.5% | $4.8 billion |
| S.No. | Name | CMP Rs. |
|---|---|---|
| 1. | NMDC | 240.90 |
| 2. | Bharat Electron | 234.45 |
| 3. | Vedanta | 370.55 |
| 4. | NBCC | 125.95 |
The Cost of Liquidity
For most individuals, excess liquidity means time out of the market, which history has shown to be a costly mistake. A more subtle and serious problem with liquidity is the temptation of what's known as easy action.
What is the downside of holding too much cash?
During bull markets, holding too much cash can limit returns, while during market busts, cash can provide a cushion. While past performance doesn't guarantee future results, cash has been shown to underperform assets like equities and bonds over the long term.
Of the ratios listed thus far, the cash ratio is the most conservative measure of liquidity. The cash ratio measures a company's ability to meet short-term obligations using only cash and cash equivalents (e.g. marketable securities).
- Current Ratio = Current Assets / Current Liabilities.
- Quick Ratio = (Cash + Accounts Receivable) / Current Liabilities.
- Cash Ratio = (Cash + Marketable Securities) / Current Liabilities.
- Net Working Capital = Current Assets – Current Liabilities.
Net income before taxes is the norm when it comes to measuring a company's profitability. Average net earnings keep increasing. This is often because companies adopt cost-saving strategies and new technology. As a rule of thumb, a good operating profitability ratio is anything greater than 1.5 percent.
Practical Example. Important to note is that a company is considered financially strong if it achieves a solvency ratio exceeding 20%.
