Importance of Liquidity Ratios
- A company's cash flow is the money in profits that it is taking in at any one time. This money is available for immediate spending by the company without any need to go through a process of liquidation or selling. Any company's cash flow is subject to change as demand rises and falls as part of the basic economic process. High cash flows allow businesses to take on greater debt without lowering their liquidity ratios.
- Private companies typically have a variety of assets that have different degrees of liquidity. It is easier, for instance, to sell and make a profit off of land than it is to sell a department. Assets can be counted as part of a typical liquidity ratio based on what they would sell for on the immediate common market. Often, assets will be undervalued by the market at any time, which makes them less certain.
- Financing is a part of the basic functioning of the modern business. Without the ability to take out debt, even large businesses would find it very difficult to operate. Debt is necessary not only to finance new projects but often to manage the everyday expenses of a business. Financing allows businesses to expand while also providing them with flexibility as regards to shifts in demand. The higher a business' liquidity ratio, the more it can do.
- Controversy has followed in the wake of certain financial scandals over how much liquidity private institutions such as banks should be required to maintain. Certain major banks failed due to the lack of funds they had available to pay their debts. The failure of financial institutions threaten not only their investors but the entire economy for which they form an infrastructure. Various countries around the world have begun to require higher liquidity in private banking.