Liquidity Coverage Ratio: Frequently Asked Questions (2024)

FAQs

What is the liquidity coverage ratio in simple words? ›

What Is the Liquidity Coverage Ratio (LCR)? The liquidity coverage ratio (LCR) refers to the proportion of highly liquid assets held by financial institutions, to ensure their ongoing ability to meet short-term obligations.

Limitations of the liquidity coverage ratio

Firstly, it requires banks to hold onto more cash. Consequently, fewer loans could be issued to businesses or consumers.

The value of the ratio should be no lower than 100% (i.e. the stock of HQLA should at least equal total net cash outflows) on an ongoing basis as the stock of unencumbered HQLA is intended to serve as a defense against the potential onset of liquidity stress.

What Is a Good LCR? Experts say that a bank should have an LCR ratio of 1:1, but this is difficult to achieve and set as it requires a bank to keep enough liquid assets or cash at any one time for the next thirty days. As such, the Financial Stability Board (FSB) recommends having a liquidity coverage ratio of 100%.

Liquidity ratios are an important class of financial metrics used to determine a debtor's ability to pay off current debt obligations without raising external capital. Common liquidity ratios include the quick ratio, current ratio, and days sales outstanding.

Liquidity ratios, which measure a firm's capacity to do that, can be improved by paying off liabilities, cutting back on costs, using long-term financing, and managing receivables and payables.

But what does the LCR (liquidity coverage ratio) mean? Put simply, the liquidity coverage ratio is a term that refers to the proportion of highly liquid assets held by financial institutions to ensure that they maintain an ongoing ability to meet their short-term obligations (i.e., cash outflows for 30 days).

Once the LCR has been fully implemented, banks should treat a 100% LCR as a minimum requirement in normal times. During a period of stress, banks would be expected to use their pool of liquid assets, thereby temporarily falling below the minimum requirement.

While an interest coverage ratio of 1.5 may be the minimum acceptable level, two or better is preferred for analysts and investors. For companies with historically more volatile revenues, the interest coverage ratio may not be considered good unless it is well above three.

When fully implemented, the final rule requires a covered company to maintain an LCR equal to or greater than 100 percent, which means that a covered company must maintain an HQLA amount equal to or greater than its projected total net cash outflows over a prospective 30-calendar-day period.

Can a liquidity ratio be too high? ›

An abnormally high ratio means the company holds a large amount of liquid assets. For example, if a company's cash ratio was 8.5, investors and analysts may consider that too high. The company holds too much cash on hand, which isn't earning anything more than the interest the bank offers to hold their cash.

Cash is the most liquid asset, followed by cash equivalents, which are things like money market accounts, certificates of deposit (CDs), or time deposits. Marketable securities, such as stocks and bonds listed on exchanges, are often very liquid and can be sold quickly via a broker.

The LCR requires banks to hold a large enough stock of high quality liquid assets (HQLA) to meet their payment obligations in the case of a severe short-term stress. The Bank also stands ready to use its balance sheet to provide liquidity insurance as appropriate.

A current ratio of 1.5 would indicate that the company has $1.50 of current assets for every $1 of current liabilities. For example, suppose a company's current assets consist of $50,000 in cash plus $100,000 in accounts receivable. Its current liabilities, meanwhile, consist of $100,000 in accounts payable.

Key Takeaways

The interest coverage ratio is used to measure how well a firm can pay the interest due on outstanding debt. The interest coverage ratio is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense during a given period.