What is Overall Liquidity Ratio
Overall liquidity ratio is the measurement of a company’s capacity to pay for its liabilities with its assets. The overall liquidity ratio is calculated by dividing total assets by the difference between total liabilities and conditional reserves. This ratio is used in insurance company analysis, as well as in the analysis of financial institutions.
BREAKING DOWN Overall Liquidity Ratio
Regulators use financial metrics, like the overall liquidity ratio, to determine whether an insurer, bank, or other financial company is healthy enough to cover its liabilities. Other similar metrics include the quick liquidity and current liquidity ratios. Quick liquidity compares liabilities to assets that are readily available for use, including cash, short-term investments, government bonds, and unaffiliated investments.
Financial and insurance companies use the cash that their activities generate to obtain a return. A bank, for example, may primarily use deposits to provide mortgages and other loans. The balance of deposits that it has left over may be kept as cash, or may be invested in liquid assets. Insurance companies are liable for the benefits that they guarantee by underwriting policies. Depending on the duration of the policy, the liability can last anywhere from a few months to a few years. Liabilities that end after one year are considered current liabilities.
The amount of money that the financial institution or insurer has to keep readily available to cover assets is determined by regulators. Regulators examine liquidity ratios to determine whether the company is complying with its legal requirements. A low overall liquidity ratio could indicate that the financial or insurance company is in financial trouble, whether from poor operational management, risk management, or investment management. A high overall liquidity ratio isn’t necessarily good either, especially if current assets represent a high percentage of total assets. A large proportion of current assets means that the company may not be earning a high enough return on assets as it may be focusing too much on liquidity.
Improving Overall Liquidity Ratio
To be able to guarantee the safety of the business loans, most lenders try to improve their liquidity ratio by laying the facts in a balance sheet. Doing this could indicate that a long-term loan, for example, could be a good strategy to improve the overall liquidity ratio. Other ways to improve the overall liquidity ratio include converting inventory to cash, delaying purchases, invoicing earlier pending orders and appraising in a higher value at the end of the year.