Liquidity Ratio

The term liquidity ratio (it is also commonly referred to as current ratio) focuses on the comparison of a company’s current assets and its current liabilities.  An asset is usually something that can be sold or is something that is financially positive for a company.  A liability is something that can be considered harmful or something that could cost the company money.  The liquidity ratio is often used by financial institutions to help determine a corporation’s ability to meet its debt obligations.  It can be compared to an individual applying for credit’s debt to income ratio.  Lenders and banks look at a person’s debt in contrast to their current flow of money coming in (income) to make credit decisions, and this method is very similar to the liquidity ratio.  Generally speaking, a liquidity ratio between 1 and 1.5 is considered favorable and the standard.  Anything above that may be considered a high risk and the company is in danger of being denied.

The purpose of the liquidity ratio is two fold.  First, the lender or bank wants to ensure that their interests are protected.  If they lend too much money to a company who has little to no assets and a high liability percentage, the fear that the company may go into default is there.  In addition, the company may not be able to repay the debt, and the bank has little recourse since there are so few assets to begin with.  The other side of this is in the company’s best interest.  Getting in over your head can be dangerous, especially in the corporate world.  If a company borrows more than they need or more than they can repay, problems will abound and can often cause companies and small businesses to go bankrupt.  The use of the liquidity ratio is very important in assisting with determining the financial and credit related pull of a company.