Importance of Liquidity Ratios
1. Determine the ability to cover short-term obligations
Liquidity ratios are important for investors and creditors to determine a company's ability to cover their short-term obligations and to what degree. A ratio of 1 is better than a ratio of less than 1, but it's not ideal.
Creditors and investors prefer to see higher liquidity ratios, such as 2 or 3. The higher the ratio, the more likely a company is to pay its short-term bills. A ratio of less than 1 indicates that the company has a negative working capital and may be facing a liquidity crisis.
2. Determine creditworthiness
Creditors analyze liquidity ratios to decide whether or not to extend credit to a company. They need to be confident that the company they lend to can pay them back. Any indication of financial instability may disqualify a company from obtaining loans.
3. Evaluate investment potential
Investors use liquidity ratios to assess a company's financial health and investment potential. A company's ability to pay its short-term bills with some leeway is essential to ensure a smooth operation.
Low liquidity ratios are a red flag, but a very high ratio may also raise questions. If a company's liquidity ratio is too high, investors may consider it excessive. For instance, a cash ratio of 8.5 is too much, as the company holds a large amount of cash that is not earning anything more than the bank's interest rate. The company should consider allocating the funds towards other initiatives and investments that can achieve a higher return.
Liquidity ratios must balance a company's ability to cover its bills with proper capital allocation. Capital should be allocated in a way that increases the firm's value for shareholders.