Introduction to Liquidity Ratios

Liquidity can be defined as the ability of a firm to make good its short term obligations. Most businesses function on credit. Hence to run a business firms have to both extend credit as well as ensure that they receive credit as well.

Liquidity ratios measure the relationship between the amounts of short term capital that the firm has locked in its receivables versus the short term interest free debt it has acquired in the form of accounts payables.

Liquidity ratios can be defined as the ratios which help analysts predict the short term solvency of the firm. Short term here is meant to be considered the period until the next business cycle which is usually 12 months.

Liquidity is the Life of a Business

A firm seldom has all the resources it needs to run the business. It gets credit from its employees, suppliers, customers, the government and such other entities. Each of these entities extends credit to the firm on the assumption that it will make good its obligations when they are due. Such obligations are usually due in the short term.

Investors are therefore very cautious about ascertaining whether the firm does in fact have the capability to meet these obligations. Liquidity ratios help in ascertaining this. With secondary data that is available in the annual reports of the company, analysts often make projections about whether the company has enough resources to survive the short run without hampering its reputation or operations.

Liquidity has an Impact on Long Term Survival of the Firm

Amateur investors think liquidity is primarily short term. It does not matter whether or not the company can pay its immediate bills, if the long term prospects of the company look good, it is a good investment. This is the farthest from the truth as history has shown liquidity issues can have far reaching effects on the health of a firm sometimes even endangering the very survival of the firm. Here is how it happens:

  • Banks Ask For Higher Interest Payments
  • Suppliers Are Wary Of Extending Credit
  • Attracting And Retaining Best Employees May Be As Issue

As a result of all these, present profitability is compromised and so are the future growth plans of the company which now has to seek funds at extremely high costs.

The best example of how liquidity problems can wreak havoc and threaten the very survival of a firm is the recent Kingfisher Airlines fiasco where the firm had to shut down operations because it could not meet its short term obligations.

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