In Canada, the liquidity ratio refers to a financial metric used to measure an individual’s or a company’s ability to cover short-term obligations with their liquid assets. Liquid assets are those that can be quickly converted into cash without significant loss in value, such as cash in a savings account, government bonds, or highly liquid investments.
Key Liquidity Ratios
There are 2 key liquidity ratios
- Current Ratio
- Quick Ratio (Acid Test Ratio)
Current Ratio
The current ratio is calculated by dividing current assets by current liabilities. This ratio measures whether an individual or a company has enough resources to pay off their short-term obligations due within a year.
Formula Current Ratio = Current Assets / Current Liabilities
Quick Ratio (Acid-Test Ratio)
The quick ratio is a more stringent measure than the current ratio as it excludes inventory from current assets. It assesses the ability to meet short-term obligations with the most liquid assets.
Formula Quick Ratio = (Current Assets – Inventory) / Current Liabilities
Liquidity and Mortgages
The liquidity ratio is relevant to mortgages in several ways
- Mortgage approval
- Debt Service Ratios
- Emergency fund and Liquidity
- Refinancing or Mortgage Renewal
- Stress Testing
Mortgage Approval
Lenders assess a borrower’s financial health before approving a mortgage. A strong liquidity ratio indicates that the borrower has sufficient liquid assets to cover short-term financial needs, including making mortgage payments in the event of income disruption. This makes the borrower less risky in the eyes of the lender and can influence mortgage approval or the terms offered.
Debt Service Ratios
While the liquidity ratio itself isn’t directly used in calculating debt service ratios like the Gross Debt Service (GDS) and Total Debt Service (TDS) ratios, it indirectly impacts them. If a borrower has a good liquidity ratio, it suggests that they can handle unexpected expenses without falling behind on debt obligations, including mortgage payments.
Emergency Fund and Liquidity
The liquidity ratio is also tied to the concept of an emergency fund. A higher liquidity ratio means that the borrower has more accessible funds to cover emergencies, which is crucial for maintaining mortgage payments during financial difficulties. This reduces the risk of mortgage default and gives lenders more confidence in the borrower’s financial stability.
Refinancing or Mortgage Renewal
When refinancing or renewing a mortgage, lenders may consider the borrower’s liquidity ratio to assess their current financial situation. A healthy liquidity ratio may lead to better refinancing terms or lower interest rates.
Stress Testing
In Canada, mortgage stress tests require borrowers to prove they can afford payments at a higher interest rate than the one they are applying for. A strong liquidity ratio can be a favourable factor during stress testing, as it shows that the borrower has a buffer to manage higher payments if interest rates rise.
Summary
In summary, the liquidity ratio is an important measure of financial health that lenders may consider when assessing a borrower’s ability to manage mortgage payments. A strong liquidity ratio indicates that the borrower has the resources to handle financial obligations, including mortgage payments, even in the face of unexpected challenges.
