Your money: why liquidity is essential for a business
By Sunil K Parameswaran
An asset is said to be liquid if it can be bought and sold easily. In other words, if the asset is trading in a liquid market, buyers can easily locate sellers and vice versa. Otherwise, if buyers outnumber sellers significantly, traders will have to increase their prices to make transactions. On the contrary, if the market is dominated by sellers, then prices will have to be lowered before a transaction takes place.
One measure of liquidity is the bid-ask spread if the market for the asset is through brokers. Dealers usually give a two-way quote i.e. one buy price and higher sell price. The difference between the two is called the spread. If transactions are rare, spreads will be high. Otherwise, if the market is very liquid, the spreads will be low.
Banks are also resellers. Their product is money. So, like other brokers, they also have a spread called net interest margin, which is the difference between their borrowing rate and their borrowing rate. If liquidity is tight, the margin will be high. Otherwise, if they are flush with the funds, the margin will be low.
A country’s central bank has various tools to influence liquidity. These include open market operations, which involve the purchase and sale of government securities, and the adjustment of reserve rates applicable to commercial banks. If the central bank buys securities, it injects money into the system and increases liquidity. On the other hand, if he wants to reduce liquidity, he can sell securities. In the case of reserves, if the central bank wants to reduce liquidity, it will increase the reserve rate. However, he wants to make more funds available to the banking sector for loans, he will reduce the reserve rate.
Companies and business analysts use certain key ratios to assess liquidity. The first is called the current ratio. It is the ratio between the current assets and the current liabilities. Current assets are called working capital and current assets minus current liabilities are called net working capital. So if the current ratio is greater than one then the net working capital will be positive, otherwise it will be negative. If net working capital is negative, it means that to some extent long-term assets are funded by short-term liabilities.
This can be a problem as short term debts need to be repaid quickly while long term assets can be difficult to sell. A more stringent measure of liquidity is the fast ratio or the acid-to-test ratio. It is calculated by subtracting inventories from current assets and then dividing by current liabilities. Thus, the rapid ratio will be lower than the current ratio. The rationale for subtracting inventory is that of all the current assets on the balance sheet, they are the most difficult to convert to cash.
Liquidity is essential for a business. In the long run, a business that is not profitable will collapse. In the short term, a business without adequate liquidity is likely to shut down. Profit and money are not the same. So, a business can be very profitable but have a lack of cash flow which can lead to a sudden shutdown of its activities.
The author is CEO of Tarheel Consultancy Services