Investors may consider allocating their assets in stocks with favorable liquidity positions for big returns. Liquidity indicates a company’s capability of meeting debt obligations by converting assets into liquid cash and equivalents.
However, one should be cautious before investing in liquid stocks. While a high liquidity level may mean that the company is meeting its obligations at a faster rate compared to others in its domain, it may also indicate that the company is failing to use its assets efficiently.
Hence, one should consider the efficiency level of a company in addition to its liquidity to identify potential winners as this combination is indicative of underlying financial strength.
Measures to Identify Liquid Stocks
Current Ratio: It measures current assets relative to current liabilities. This ratio is used for measuring a company’s potential to meet both short- and long-term debt obligations. Thus, a current ratio — also known as working capital ratio — below 1 indicates that the company has more liabilities than assets. However, a high current ratio does not always indicate that the company is in good financial shape. It may also mean that the company has failed to utilize its assets significantly. Hence, a range of 1 to 3 is considered ideal.
Quick Ratio: Unlike current ratio, quick ratio – also called “acid-test ratio” or “quick assets ratio” – indicates a company’s ability to pay short-term obligations. It considers inventory excluding current assets relative to current liabilities. Like the current ratio, a quick ratio of greater than 1 is desirable.
Cash Ratio: This is the most conservative ratio among the three, as it takes into account only cash and cash equivalents, and invested funds relative to current liabilities. It measures a company’s ability to meet its current debt obligations using the most liquid of assets. Though a cash ratio higher than 1 may point to sound financials, a high number may indicate inefficiency in cash utilization.