Banks calculate their liquidity position for a variety of reasons. Liquidity refers to the bank’s ability to convert assets to cash and its ability to pay its financial obligations by their due date. Banks use financial ratios to calculate their liquidity position. These include working capital and the current ratio. Working capital considers the total dollars available after meeting the bank’s current debt payments. A higher working capital represents a higher level of liquidity for the bank. The current ratio considers the relationship between the bank’s near-cash assets to its current obligations. A higher current ratio represents a higher level of liquidity.
Understanding Bank Liquidity
Before you get started, fully understand the information you're trying to extract. Liquidity is based on each account’s relationship to cash. In a bank, cash represents many more types of accounts than it does in other businesses. Cash serves as the primary product of the bank, such as when the bank lends money to a consumer. Cash also serves as the focus of the services provided by the bank, such as safeguarding cash for the consumer. The bank records several cash accounts in its financial records, including current assets, long-term assets and current liabilities.
Reviewing the Balance Sheet
To get started, gather the balance sheet and acquaint yourself with all of the figures on it. First, pay close attention to the current assets. The current assets of a bank include cash receivables from other banks or marketable securities. On the same balance sheet, you'll also find the current liabilities. The current liabilities of a bank include customer deposits or dividends owed to stockholders.
Calculating the Bank's Liquidity
Subtract the current liabilities from the current assets. This calculates working capital. Once you have that total, divide the current assets by the current liabilities. This calculates the current ratio.
Considering Other Calculations
Use a variety of calculations to evaluate the financial position of the bank. Liquidity only represents one aspect of the bank’s financial position. Bank managers also analyze solvency and profitability. Solvency refers to the bank’s ability to remain in existence. Profitability refers to the bank’s ability to earn a return for the stockholders.
Adjusting for Bank Size
The working capital calculation only allows you to compare liquidity for banks of similar sizes. A larger bank will have a larger working capital, regardless of how liquid it is. The current ratio allows you compare banks of different sizes.
