A metric that points to the likelihood of paying off debt without resorting to raising capital.

Companies are in a constant flux between their revenue level and their debt liability level. Between these two ends lies the liquidity ratio. When investors look at any company or cryptocurrency, one of the first things they look at are market cap and liquidity. If a company has high liquidity, it means it can meet its obligations without raising additional capital.

In other words, its liquidity ratio would be high because it could more easily pay off any outstanding debts. On the other hand, a highly indebted company with a subpar revenue flow, would have to seek out additional funding models. This means that its liquidity ratio would be low.

Commonly, investors would try to short-sell such companies, if they are publicly traded. For instance, hedge funds shorted both GameStop (GME) and AMC Entertainment (AMC) amid the first wave of lockdowns. They took a bet that their stock shares would crumble amid the first wave of lockdowns that had negatively impacted their business models.

While it turned out that retail traders turned the short-selling game around, by short-squeezing the hedge funds, it still remains the fact that both companies have low liquidity ratios. There are several types to consider according to the liquidity ratio formula:

  • The current ratio is the most common one, expressed as current assets divided by current liabilities. The higher it is, the better the company stands.

  • The quick ratio is the company's capability to meet its short-term debt obligations. The formula is: (C+MS+AR)/CL, where C represents cash or cash equivalents, MS is marketable securities, AR is accounts receivable, and CL is current liabilities.

  • Days Sales Outstanding (DSO) is the company's ability to collect payment after selling its products, numbered in days. Therefore, the formula is DSO = average accounts receivable/revenue per day.

From this follows that even healthy companies with high liquidity can end up having a bad liquidity ratio. For instance, China's giant real estate developer, Evergrande, affects the revenue of hundreds of companies it deals with. If it defaults on its debt, which appears to be imminent, this would have a cascading effect on the entire real estate ecosystem.

Because other companies depend on Evergrande paying off its liabilities, they would suddenly find themselves in a situation in which they wouldn't be able to meet their own payment obligations. This is why the People's Bank of China (PBoC) had designated Evergrande as having systemic risk for the entire Chinese economy.