The ratio of liquid assets to current liabilities. Liquid assets are cash, and items readily convertible into cash, but not stock or work in progress, though stock could be included if it consisted of goods bought for resale for cash rather than credit. The term ‘hquid ratio’ has a particular significance in the banking world. Banks. by tradition, lend money which they do not possess, and usually a bank will only be called upon to pay over in cash to customers a small percentage of total credit balances. This means that the banks can invest customers’ money at interest rates which are high, but where the profitability depends upon the money not being available for recall at short notice. Furthermore, banks lend monies deposited by one customer to another for a fixed period, and may also issue bank notes. These practices have evolved over many centuries and spring from the knowledge that a limited minimum amount of cash will support daily withdrawals, e.g. £10cash may suffice to support a total of £100 in outstanding customer accounts. This minimum sum is expressed as a proportion of total debts and that ratio is known as the bank’s liquidity ratio. In the case instanced, it is £10 or 10 per cent. If all customers called in their accounts at once a bank would be forced to close its doors and admit failure, and this has happened on various occasions in the history of banking – as recently as the nineteenth century. In present times the principal clearing banks, particulariy in the U.K., are protected by the willingness of the central bank of their country to support them in any crisis and also by the fact that no responsible government could afford the international ill-will that would necessarily flow from large-scale bank failures.
Reference: The Penguin Business Dictionary , 3rd edt.