Over the past decade China and other emerging economies have accumulated huge foreign currency reserves. One of the reasons behind this massive accumulation of foreign reserves has been huge demand of commodities, which has allowed countries like Brazil to benefit immensely through commodities and raw materials exports. In China’s case, exports of cheap manufacturing goods have allowed the country to accumulate huge foreign currency reserve.
Huge foreign reserves have also ensured that that countries like China, Brazil, India and other south- East Asia’s fast growing economies like Malaysia etc. continue to wither global financial crisis and subsequent recession with more vigor. These countries are weathering the financial crisis storm relatively better than those who have bought less financial insurance. Indeed, if we look at some of eastern European economies like Latvia, Hungary or other ex USSR nations, we will find that since the start of the financial crisis in late 2008, these countries are struggling with their economy. The main reason behind this downward trend was they were too reliant on foreign capital and after the financial crisis when the global liquidity dried up; these countries have found themselves in precarious situation.
Although purchasing insurance policy might have been sensible from the perspective of each country, collectively these currency interventions prepared the ground for global crisis. Emerging markets, most notably china, helped to create the macroeconomic backdrop for the current financial crisis by subsidizing interest rates and consumption of the US.
Over the next few articles, we will look at the causes of global imbalances and how the situation can be rectified. We will look at how financial globalization resulted in the global financial crisis of 2008. We will also see how China accumulated huge foreign currency reserves over the year. More importantly, we will look at the impact this massive imbalance has had on the global economy and how it the imbalance can be reversed.
Liquidity is very essential for companies as it helps in maintaining short term financial health. Every company has some sort of financial obligation in the short term and investments needs; hence failing to keep the liquidity affects company’s operations badly. The rationale is if company cannot secure its future in the short term then how can it survive in the long term? That’s the reason why investors should find out and must know how to find out the company’s short term financial health.
Under financial market or stock trading a liquid stock means how much in the short term (degree) an investor is willing to buy a stock of a particular company. In other words liquidity means a how quickly a stock can be converted into cash.
Let us now understand the concept of liquidity through following example. A company has two types of assets: a fixed asset, say, land worth R$150,000 and a current asset of R$150,000 in the form of cash equivalent instruments which can be quickly converted into cash. Now, even though both assets worth the same amount; both have different implications on company’s short term health. The cash equivalent instruments being highly liquid can be quickly converted into cash; but land being illiquid asset, selling could take any amount of time. It is difficult to predict when the company will realize cash from the land sell proceeds. So, if the company has negative working capital (outflow of cash is more than the inflow) then cash equivalents are useful assets as company can finance its short term need like paying wages, buying materials etc on its own.
Some useful ratios
Investors can look at financial statements of a company to find out ratios which shows to what extent the company is liquid.
Current ratio: This is a very useful ratio which compares company’s current liabilities with current assets. The formula for defining current ratio is Current Assets/current liabilities. This means that for every 1 dollar worth of current asset how much the company is indebted by current liabilities. Accordingly, if the ratio is 1 then it is believed that company will be able to meet its short financial requirements. If the ratio is less than 1 , company is likely to face shortfall in short term financing. For analyzing current ratio, investors should always consider companies operating under the same industry for comparing the current ratios.
Quick ratio: Quick ratio or acid test ratio is slightly vigorous test of company’s liquidity. According to this method, companies’ current assets are calculated excluding the inventories to find out whether they are capable of paying current liabilities. If the acid test shows that the ratio less than 1 then it means a company is heavily dependable on inventories. The formula to calculate acid ratio is (cash+ Bills receivables + cash equivalent investments)/ current liabilities.
Interest coverage: Interest coverage ratio indicates how much interest expenses on debt are covered by company’s cash flow. So, if the ratio is 1 or less than 1 then it will mean that company has lot of problems in generating cash to cover interest expenses. If the ratio is 1.5 or exceeds then it will mean that company has sufficient cash flow to look after its interest expenses. The formula to calculate interest ratio is EBIT/interest expenses.