What Is Liquidity and Why Is it Important for Firms?
Liquidity refers to how easily or efficiently cash can be obtained in order to pay bills and other short-term obligations. Assets that can be readily sold, like stocks and bonds, are also considered to be liquid (although cash is, of course, the most liquid asset of all). Businesses need enough liquidity on hand to cover their bills and obligations so that they can pay vendors, keep up with payroll, and keep their operations going day-in and day-out.
How Does Liquidity Differ from Solvency?
Liquidity refers to the ability to cover short-term obligations. Solvency, on the other hand, is a firm’s ability to pay long-term obligations. For a firm, this will often include being able to repay interest and principal on debts (such as bonds) or long-term leases.
Why Are there Several Liquidity Ratios?
Fundamentally, all liquidity ratios measure a firm’s ability to cover short-term obligations by dividing current assets by current liabilities (CL). The cash ratio looks at only the cash on hand divided by CL, while the quick ratio adds in cash equivalents (like money market holdings) as well as marketable securities and accounts receivable. The current ratio includes all current assets. Thus, the different ratios differ in how conservative they are: While it is relatively easy to sell stocks, it may take a day or two to clear. Cash, however, is already available to pay bills.
What Happens if Ratios Show a Firm Is not Liquid?
In this case, a liquidity crisis can arise even at healthy companies—if circumstances arise that make it difficult to meet short-term obligations, such as repaying their loans and paying their employees or suppliers. One example of a far-reaching liquidity crisis from recent history is the global credit crunch of 2007-09, where many companies found themselves unable to secure short-term financing to pay their immediate obligations. If new financing cannot be found, the company may be forced to liquidate assets in a fire sale or seek bankruptcy protection.