Liquidity refers to the amount of money that is promptly available to meet debts or to use for investment. It indicates the levels of cash available and how quickly a financial asset or security can be converted into cash without losing significant value.
Different Types of Liquidity Ratios:
Current Ratio = Current Assets / Current Liabilities
Quick Ratio = (Cash + Accounts Receivables + Marketable Securities) / Current Liabilities
Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
The liquidity ratio helps to understand the cash richness of a company. It also helps to perceive the short-term financial position. A higher ratio implies the stability of the company. Contrarily, a poor ratio carries a risk of monetary damages.
This ratio provides the complete idea of the concerned company’s operating system. It depicts how effectively and efficiently the company sells its product or services to convert the inventories into cash. With the help of this ratio, a company can improve the production system, plan better inventory storage to avoid any loss, and prepare effective overhead expenses.
Why Liquidity is Important to You:
The importance of liquidity revolves around you. For example, you would have to evaluate how liquid your investments are and if it is compatible with your short-term or long-term goals. If you somehow need cash quickly in the future, investing it into a very illiquid investment may be unwise. The importance of liquidity depends on how you value these issues.
High Liquidity Short-term, Lower Liquidity Long-term:
Some long-term investments are likely to have stable payouts similar to the nature of bonds. However, high liquidity investments may return a lower sum versus investments with higher liquidity. When investing, it is important to consider if you will need money soon in the future, or you are comfortable without touching your investments.
Written by Anna Li