Liquidity means the ease or efficiency with which assets of a firm,
or an individual can be converted into cash without affecting its
market price. Cash is considered the most liquid asset, while tangible
assets are considered less liquid. It also refers to the cash or
assets banks have which are quickly available and can be used to meet
any financial obligations or short-term business needs. Let’s look at
an example to understand liquidity.
Let’s say you want to buy a
bike worth Rs. 5 Lakh. In this case, cash will be the most quickly
available liquid asset that you may use. However, if you don't have
enough cash for the bike, but you have a rare art collectable worth
the same price, it will be unlikely to find a seller who will exchange
the bike for that collectable. Instead, you will have to sell the
collectable to obtain cash for the bike. This could work if you can
wait to purchase the bike. However, if you need bike immediately, it
could pose a problem. You might think of selling your collectable at a
discount, but it might be hard to find a buyer who will pay for its
actual worth. Hence, such assets are considered illiquid.
What is liquidity in banking?
Liquidity in banking is the measure of a bank's cash or other
assets that can be used for meeting financial obligations. Some common
examples of liquid assets include cash, marketable securities, assets,
and cash equivalents. Liquidity is an important factor to understand
how easily and efficiently a company can pay off its debt and
liabilities. Anything greater than 1 is considered a good liquidity
ratio. It indicates that the company is in good financial health and
is less likely to experience heavy financial hindrances. If a
company’s liquidity ratio is high, it means the company has enough
safety margin to meet its current liabilities.
Liquidity also
applies to an individual. The greater an individual’s liquid assets,
i.e., cost savings and investment portfolio, the better their
financial situation.
How to measure liquidity
Financial institutions and analysts check a firm’s ability to use its liquid assets to tackle any short-term financial obligations by using those assets. A liquidity ratio greater than 1 is considered good. Below are some formulae used to calculate the liquidity ratio.
- Current Ratio
The current ratio is the simplest and most lenient. It measures the most liquid assets, the ones that can be converted into cash within a year, against current liabilities. The formula used for the current ratio is: Current Ratio = Current Assets/Current Liabilities
- Acid Test Ratio/ Quick Ratio
The quick ratio, or acid test ratio, considers inventories, cash equivalents, short-term investments, and account receivables, as these are considered the most liquid. The formula for acid test/quick ratio is: (Cash and Cash Equivalents + Accounts Receivable + Short-term Investments)/Current Liabilities)
- Cash Ratio
The cash ratio is the most straightforward and exacting out of all ratios. It strictly excludes other forms of liquid assets such as inventories, other current assets, and accounts receivable. It only considers cash and cash equivalents as liquid assets.
This ratio is mainly used to assess a company’s ability to stay solvent in case of emergencies. No matter how stable a company is, having enough liquidity to deal with unforeseen events that might put it in an unmanageable state is imperative. The formula for the cash ratio is: Cash and Cash Equivalents/Current Liabilities.
Also Read: 7 Useful Tips for Money Management
How does liquidity affect interest rates?
Interest rates, essentially the cost incurred on borrowing funds,
fluctuate based on total monetary funds available in the financial
system at present or at any given moment. In case there is limited
money in the system, the interest rates rise, which could lead to an
economic slowdown.
If interest rates fall too far, it could
potentially lead to high levels of inflation. To balance this out,
financial institutions can purchase securities to maintain the
availability of money in the system. They can also sell these
securities to remove money from the system, only to maintain healthy
interest rates for all.
Summing Up
The liquidity of a company is important as it shows the financial
stability of the company. In addition to this, it also gives you an
idea about how a company can mitigate or handle a financial crisis.
This can be a crucial factor for those who are looking to invest.
When it comes to instant Personal
Loan interest rates or Business Loan
interest rates, liquidity has a role to play. However, your credit
score, monthly income, debt-to-income ratio, and credit history
are the factors that impact the interest rates the most.
