interest rate liquidity

Understand How Liquidity Affect Interest Rates

October 28, 2022 • 178 views

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. 

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