A:

In terms of corporate financing, liquidity ratios describe the ability of a firm to pay off short-term debt obligations with cash on hand or short-term assets. Common liquidity ratios include the current ratio and the acid test ratio, also known as the quick ratio. Investors and lenders look to liquidity as a sign of financial security; for example, the higher the liquidity ratio, the better off the company is, to an extent.

It is more accurate to say that liquidity ratios should fall within a certain range. Companies with excessively low liquidity ratios place themselves at risk of default and may find it difficult to raise capital. On the other hand, companies with liquidity ratios that are too high might be leaving workable assets on the sideline; cash on hand could be employed to expand operations, improve equipment, etc.

Take the time to review the corporate governance for each firm you analyze. The circumstances for every business and industry are different, making it difficult to create a universal benchmark for healthy liquidity ratios. The best practice for investors, lenders and managers is to consider liquidity ratios of successful competitors and historical trends. Since liquidity ratios describe the relationship between debt and assets, the correct amount of short-term assets on hand rises proportionately with increased levels of leverage.

Some industries successfully operate with low liquidity ratios. For example, inventory might turn over more quickly than accounts payable payments are made, making it seem as if short-term assets are unreliable. In circumstances such as these, it could be useful to look at operation cycle periods. The cash conversion cycle is a good metric for this, as it measures the number of days a company's cash is tied up in the production and sales process.

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