doesn t account for dynamic cash flows
focuses solely on short term liquiditymay overlook profitability and solvency issuescomparisons across industries can be challenging or misleadingspecial considerationsa liquidity crisis can arise even at healthy companies if circumstances arise that make it difficult for them to meet short term obligations such as repaying their loans and paying their employees the best example of such a far reaching liquidity catastrophe is the global credit crunch of 2007 09 commercial paper short term debt that is issued by large companies to finance current assets and pay off current liabilities played a central role in this financial crisis a near total freeze in the 2 trillion u s commercial paper market made it exceedingly difficult for even the most solvent companies to raise short term funds at that time and hastened the demise of giant corporations such as lehman brothers and general motors gm 2however unless the financial system is in a credit crunch a company specific liquidity crisis can be resolved relatively easily with a liquidity injection as long as the company is solvent this is because the company can pledge some assets if it is required to raise cash to tide over the liquidity squeeze this route may not be available for a company that is technically insolvent because a liquidity crisis would exacerbate its financial situation and force it into bankruptcy solvency ratios vs liquidity ratiosin contrast to liquidity ratios solvency ratios measure a company s ability to meet its total financial obligations and long term debts solvency relates to a company s overall ability to pay debt obligations and continue business operations while liquidity focuses more on current or short term financial accounts a company must have more total assets than total liabilities to be solvent a company must have more current assets than current liabilities to be liquid although solvency does not relate directly to liquidity liquidity ratios present a preliminary expectation regarding a company s solvency the solvency ratio is calculated by dividing a company s net income and depreciation by its short term and long term liabilities this indicates whether a company s net income can cover its total liabilities generally a company with a higher solvency ratio is considered to be a more favorable investment profitability ratios vs liquidity ratiosprofitability ratios measure a company s ability to generate profit relative to its revenue assets or equity these ratios assess the efficiency and effectiveness of a company s operations providing insights into its ability to generate returns for shareholders in contrast liquidity ratios focus on a company s ability to meet its short term financial obligations promptly while profitability ratios focus on generating returns and maximizing profits liquidity ratios prioritize maintaining sufficient liquidity it s important to understand these are vastly different things a company can have sufficient money on hand to operate if it s built up capital however it may be draining the amount of reserves it has if operations aren t going well alternatively a company may be cash strapped but just starting out on a successful growth campaign with a positive outlook both types of ratios are essential for assessing different dimensions of a company s financial performance and risk profile investors and analysts often use them in combination to gain an understanding of a company s financial health note that a company may be profitable but not liquid and a company can also be highly liquid but not profitable example of using liquidity ratioslet s use a couple of these liquidity ratios to demonstrate their effectiveness in assessing a company s financial condition consider two hypothetical companies liquids inc and solvents co with the following assets and liabilities on their balance sheets figures in millions of dollars we assume that both companies operate in the same manufacturing sector i e industrial glues and solvents note that in our example we will assume that current liabilities only consist of accounts payable and other liabilities with no short term debt we can draw several conclusions about the financial condition of these two companies from these ratios liquids inc has a high degree of liquidity based on its current ratio it has 3 of current assets for every dollar of current liabilities its quick ratio points to adequate liquidity even after excluding inventories with 2 in assets that can be converted rapidly to cash for every dollar of current liabilities however financial leverage based on its solvency ratios appears quite high debt exceeds equity by more than three times while two thirds of assets have been financed by debt note as well that close to half of non current assets consist of intangible assets such as goodwill and patents as a result the ratio of debt to tangible assets calculated as 50 55 is 0 91 which means that over 90 of tangible assets plant equipment inventories etc have been financed by borrowing to summarize liquids inc has a comfortable liquidity position but it has a dangerously high degree of leverage solvents co is in a different position the company s current ratio of 0 4 possibly indicates an inadequate degree of liquidity with only 0 40 of current assets available to cover every 1 of current liabilities the quick ratio suggests an even less liquid position with only 0 20 of liquid assets for every 1 of current liabilities financial leverage however appears to be at comfortable levels with debt at only 25 of equity and only 13 of assets financed by debt even better the company s asset base consists wholly of tangible assets which means that solvents co s ratio of debt to tangible assets is about one seventh that of liquids inc approximately 13 versus 91 overall solvents co is in a potentially dangerous liquidity situation but it has a comfortable debt position 