Question: Differentiate between liquidity ratios and leverage ratios
This question was asked in KNEC exam for Business Finance, Diploma in Business Management
Answer:
Liquidity ratios and leverage ratios are both financial metrics used in financial analysis to assess the financial health of a company. Although these metrics deal with financials or money matters, they have different areas of focus.
Liquidity ratios measure the ability of a business to meet its short term financial obligations using current assets. They show whether a company can be able to cover its short term liabilities using short term assets. The key liquidity ratios are: current ratio, quick ratio and cash ratio. Liquidity ratios focus on short term financial health and operating efficiency of a company.
On the other hand, leverage ratios measure the degree to which a company finances its operations or assets using debt. It has a lot to do with debt and equity – how much debt a company raises to fund its investments and operations compared to equity. This ratio focuses on long term stability of a business as well as risk management.
So, the key differences between liquidity and leverage ratios are: time horizon, primary concern, and nature of financial analysis. In terms of time horizon, liquidity ratios focus on short term financial health while leverage ratios assess long term financial health. Liquidity ratios’ primary concern is on short term liabilities while the primary concern of leverage ratios is level of debt. Lastly, liquidity ratios deal with cash flows while leverage ratios deal with capital structure and debt management.
