While in certain scenarios, a high liquidity value may be key, it is not always important for a company to have a high liquidity ratio. The liquidity ratio of a company is calculated by dividing all company assets by the difference between liabilities and conditional reserves. The basic function of the liquidity ratio is to measure a company’s capability to settle all current debt with all current available assets. The stability and financial health, or lack thereof, of a company and its efficiency in paying off debt is indicated by liquidity ratios and is of great importance to market analysts, creditors and potential investors.
Why a High Liquidity Ratio Isn't Essential
The lower the liquidity ratio, the greater the chance the company is, or may soon be, suffering financial difficulty. Still, a high liquidity rate is not necessarily a good thing. A very high value resulting from the liquidity ratio may be a sign the company is overly focused on liquidity, which can be detrimental to the effective use of capital and expansion of the business. A company may have a very impressive-looking liquidity ratio but precisely because of its high liquidity level, it may present an unfavorable picture to analysts and investors who then consider other measures of a company's performance such as the profitability ratios of return on capital employed (ROCE) or return on equity (ROE). ROCE is a measurement of company performance in regard to how efficient a company is at making use of available capital to generate maximum profits. It does this through a formula that calculates capital used in relation to net profit generated.
Ultimately, every company's owners or executives need to make decisions regarding liquidity that are tailored to their specific companies. There are a number of tools, metrics and standards by which profitability, efficiency and value of a company can be measured, and it is important for investors and analysts to evaluate a company from several different perspectives to obtain an accurate overall assessment of a company's current value and future potential.