Should Companies Always Have High Liquidity?
What Is High Liquidity?
A company’s liquidity indicates its ability to pay debt obligations, or current liabilitieswithout 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 liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency. Liquidity is typically measured using the current ratio, quick ratioand operating 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 healthor lack thereof, of a company and its efficiency in paying off debt is of great importance to market analysts, creditorsand 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 (YEAR) 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, metricsand 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.