What is overall liquidity? How important is this metric? [See the formula]

THE general liquidity is an essential concept in the world of finance, widely used to assess a company's ability to meet its financial obligations.

Our goal here today is to explore in detail what overall liquidity is and what it's for, preparing you for an in-depth understanding of this indicator.

We'll cover how to analyze overall liquidity, explaining the calculation methods and how to interpret the results. We'll also discuss the importance of this metric for different stakeholders, including investors, creditors, and managers. By the end of this article, you'll be equipped with the knowledge you need to understand and apply overall liquidity to assess a company's financial health.

See this article:

• What is general liquidity?
• What is general liquidity for?
• How do I know if my company's overall liquidity ratio is good?

What is General Liquidity?

The liquidity ratio is a financial indicator that measures a company's ability to pay its total debts, including both short-term and long-term debts.

This indicator offers a more comprehensive view of the company's financial health, considering all relevant assets and liabilities.

In simple terms, overall liquidity is calculated by the sum of current assets and long-term realizable assets, divided by the sum of current liabilities and long-term liabilities.

To better understand, let's consider a practical example. Imagine a company that has $500,000 in current assets, such as cash and accounts receivable, and $300,000 in long-term assets, such as long-term investments. At the same time, this company has $400,000 in current liabilities, which include short-term debt and accounts payable, and $200,000 in long-term liabilities, such as long-term loans.

Applying these values to the formula, we have:

General Liquidity = (500.000 + 300.000) / (400.000 + 200.000) = 800.000 / 600.000 = 1,33

This means that for every dollar of total debt, the company has $1.33 in assets available for payment, indicating a relatively healthy financial position.

Overall liquidity is a valuable tool for analyzing a company's financial stability and its ability to meet financial commitments, providing important insights for investors, creditors, and managers.

What is the purpose of general liquidity? What is it for?

Overall liquidity is a crucial metric for assessing a company's financial health, as it indicates the company's ability to pay its total obligations, encompassing both short-term and long-term debt. Paying attention to this metric is essential for multiple stakeholders, each with their own vested interest in the company's stability and solvency.

Utility of General Liquidity

Now see some of the uses of the general liquidity index:

1) Assessment of Long-Term Solvency:

• What is it: Unlike other liquidity ratios that focus only on the short term, overall liquidity also considers long-term assets and liabilities.
• Importance: This provides a more complete view of the company's ability to service all of its debts over time, not just its immediate ones.

2) Internal Decision Making:

• Managers and Administrators: They use overall liquidity to make strategic decisions, such as the need to raise funds, adjust cash flow, or renegotiate payment terms. Good overall liquidity suggests a company is in a solid financial position, allowing for more secure planning and investment.

3) Investment Decisions:

• Investors: They use overall liquidity to assess a company's security and financial stability before investing. Companies with good overall liquidity are seen as safer, as they have sufficient resources to weather financial difficulties and meet their obligations.

4) Risk Assessment for Creditors:

• Banks and Financial Institutions: Lenders analyze overall liquidity to assess the risk of granting loans or lines of credit. High overall liquidity indicates a greater repayment capacity, reducing the risk for the lender.

5) Comparative Analysis:

• Benchmarking: Companies can compare their overall liquidity with that of others in the same industry to understand their relative position in the market. This helps identify strengths and weaknesses relative to the competition.

Situations where General Liquidity is Crucial:

• Financial Planning: When developing long-term plans, overall liquidity helps ensure that the company will maintain its ability to pay over time.
• Debt Negotiation: When negotiating payment terms or conditions with creditors, overall liquidity provides a solid basis for demonstrating the company's ability to pay.
• Mergers and Acquisitions Assessment: In merger or acquisition processes, analyzing overall liquidity is essential to assess the financial health of the target company.
• Financial Crises: In times of crisis, overall liquidity is a key metric for assessing a company's resilience and its ability to weather periods of economic difficulty.

How do I know if my company's overall liquidity ratio is good?

Determining whether your company's overall liquidity ratio is healthy involves comparing it to industry benchmarks, assessing its trends over time, and considering your company's specific needs. Here are some guidelines to help with this analysis:

1. Comparison with Industry Benchmarks

• Industry Standards: Each industry has its own standards and expectations regarding overall liquidity. For example, companies in sectors like retail or manufacturing may have different standards than those in technology or financial services.
• Comparative Analysis: Compare your overall liquidity ratio to that of other companies in the same industry. This can be done through market reports, trade associations, or financial databases. If your ratio is close to or above the industry average, this generally indicates a healthy position.

2. Trends Over Time

• Historical Analysis: Examine how your company's overall liquidity ratio has behaved over time. A steadily improving ratio suggests effective financial management and improved payment capacity.
• Pattern Identification: If the index is falling, this could be a warning sign indicating potential future financial difficulties. It's important to identify and address the causes of this decline.

3. Company Needs and Context

• Company Life Cycle: Companies at different stages of growth may have different liquidity needs. Startups may operate with lower liquidity ratios due to high initial investments, while mature companies must maintain higher ratios to ensure stability.
• Business Strategy: Consider your company's plans and strategies. If you're planning expansion or significant investments, a higher liquidity ratio may be necessary to support these initiatives.

4. Common Reference Values

• General Rule: A liquidity ratio above 1 is generally considered healthy, as it indicates that the company has sufficient assets to cover its total debts. Values below 1 can be a warning sign, indicating that the company may have difficulty meeting its financial obligations.
• Ideal Intervals: Depending on the industry and the company's specific circumstances, an ideal liquidity ratio can range from 1.2 to 2.0. Very high ratios, however, may suggest that the company is holding too much cash in liquid assets rather than investing in growth.

5. Detailed Component Analysis

• Asset Quality: Assess the quality of current and long-term assets. High-quality assets that are easily convertible into cash are more valuable for overall liquidity.
• Debt Structure: Examine the composition of liabilities. Short-term versus long-term debt has different implications for cash flow management.

What are the other types of liquidity?

Understanding the different types of liquidity—general, current, immediate, and dry—is essential for a comprehensive analysis of a company's financial health. General liquidity, by considering all of a company's debts, provides a holistic view of its payment capacity. Meanwhile, current liquidity focuses on short-term debt, and dry liquidity excludes inventories, providing a more restricted and conservative view. Finally, immediate liquidity highlights the ability to make immediate payments, without the need to sell inventory or receive payments. These different aspects of liquidity are crucial for managers, creditors, and investors to assess a company's financial stability and make strategic decisions.

In summary:

• Current Liquidity: Measures a company's ability to pay its short-term debts with its current assets. It is useful for assessing the company's ability to pay immediately.
• Dry Liquidity: Similar to current liquidity, but excludes inventories, providing a more conservative view of short-term liquidity. It is used when a more prudent analysis of immediate payment capacity is desired.
• Immediate Liquidity: Focuses on the most liquid assets, such as cash and equivalents, to pay short-term debts. It is useful for assessing the ability to meet urgent obligations without relying on receivables or inventory.

Knowing whether your company's overall liquidity ratio is healthy requires a multifaceted analysis, taking into account industry benchmarks, historical trends, the business context, and common reference values. A comprehensive approach will allow you to assess your company's financial health more accurately and make informed decisions to maintain or improve its payment capacity.