What are liquidity ratios and how is it important in telling me whether or not it is a good choice to invest in a certain company? - Seedly
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Anonymous

Asked on 12 Mar 2019

What are liquidity ratios and how is it important in telling me whether or not it is a good choice to invest in a certain company?

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Paridhi Jhunjhunwala
Paridhi Jhunjhunwala, Associate at Kristal.AI
Level 7. Grand Master
Answered on 15 Nov 2019

Hi!

Liquidity ratios are those which help you to assess the ability of a firm to repay its debts. This is important for investors in both debt and equity instruments. For the debt owner, if the company is unable to repay their claims, they will lose their capital. Equity owners will receive income through dividends only after the debt obligations are clear. Hence, having a good liquidity ratio shows that the company will be able to repay its obligations.

Liquidity ratios can be as follows:

  1. Current Ratio

  2. Quick Ratio

  3. Operating Cash Flow Ratio

However, agreeing with the others, these ratios are only helpful when used in comparison to other firms. Then we can take a call upon which company has a better liquidity position than the other. These numbers in isolation will not make much sense.

I work at Kristal.AI, and it's my passion to evaluate various upcoming investment opportunities.

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Isaac Chan
Isaac Chan, Business at NUS
Level 8. Wizard
Answered on 12 Mar 2019

Building on Zann's answer, liquidity ratios can help you understand the credit strength of the company. For a retail investor, this could be more important if you would like to buy bonds from this company, since one of the risks associated with buying bonds is the default risk of a company. For this, you might wanna read up also on leverage, coverage and solvency ratios since I feel that liquidity ratios alone won't be sufficient and definitely the credit ratings given by rating agencies.

Something else that might be relevant could also be what liquidity ratios are being used for comparison. Current, quick and cash ratios tell you different things about a company and what kind of working capital policies that they have. For example, holding too much cash may not be a good thing because it means that the company isn't investing the cash to expand the business, while holding a disproporitonate amount of inventory is also bad since cash is tied up there.

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Zann Chua
Zann Chua
Level 6. Master
Answered on 12 Mar 2019

Hello!

Liquidity ratios can be used to determine whether a company or a debtor is able to pay off its current debt without the need to raise external capital. some examples of liquidity ratios are current ratio and operating cash flow ratio.

liquidity ratios are most useful when they are used in comparative form.

hope this helps!

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Going to be a bit controversial here but I'd say these ratios are useless for deciding which companies to invest in.

Happy to be corrected by anyone who is serious trader who could share their experiences

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