Understanding Liquidity Ratios: How Do They Impact a Company's Financial Health?

Understanding Liquidity Ratios

Liquidity ratios are the ratios that measure the ability of a company to meet its short-term debt obligations. These ratios assess the company's capacity to pay off its short-term liabilities when they fall due.

Generally, the higher the liquidity ratios are, the higher the margin of safety that the company possesses to meet its current liabilities. Liquidity ratios greater than 1 indicate that the company is in good financial health and is less likely to fall into financial difficulties.

Common Examples of Liquidity Ratios

The most common examples of liquidity ratios include the current ratio, acid test ratio (also known as quick ratio), cash ratio, and working capital ratio. Different assets are considered relevant by different analysts. Some analysts consider only cash and cash equivalents as relevant assets because they are most likely to be used to meet short-term liabilities in an emergency. Some analysts consider debtors and trade receivables as relevant assets in addition to cash and cash equivalents. Some analysts also consider the value of inventory.

A company must possess the ability to release cash from the cash cycle to meet its financial obligations when creditors seek payment. In other words, a company should possess the ability to translate its short-term assets into cash. The liquidity ratios attempt to measure this ability of a company.

It may be irrelevant to some members, but such inputs may be useful to other members who are handling wage negotiations (company's financial position, capacity to pay, etc.). It will be relevant to members who handle Wage and Salary administration, which involves decisions relating to the percentage to be offered as increments. Sustaining the capacity to pay is key, and such information will shed light on crucial decisions.

This information will also be valuable for HR personnel who are in charge of recruitment. These questions can be posed to candidates to assess their knowledge levels during a preliminary round for a finance position.

Thank you, Mr. Sagar, for the input provided. I found it useful.

Regards,
M. V. Kannan

Mr. Kannan, will you be in a position to explain the usefulness of these ratios with the help of some examples to enable the HR fraternity to understand their utilization in planning HR budgets for the organization?

Thank you for your enlightened input establishing a relationship between the need for liquidity and the liability of HR to discharge certain sudden pecuniary liabilities. Sometimes, a company may receive an order from a court to deposit a certain amount, which may run into a few lakhs during the pendency of an appeal. Alternatively, it may receive an order from a court to pay back wages amounting to a few lakhs for its illegal termination, specifying a time limit to discharge its liability. These liabilities cannot be postponed but must be complied with within a specified time frame. Only a company with sound liquidity can meet sudden financial contingencies.

Regards,
B. Saikumar
HR & Labour Law Advisor
Mumbai