Cash Liquidity
To measure a company’s liquidity is to measure that organization’s ability to meet its short-term financial obligations, its ability to take advantage of opportunities, and to deal with crises as they arise. In a financial sense, liquidity refers to convertibility to cash. To have liquidity is to imply that the company bears a relatively low level of risk of bankruptcy or insolvency.
Cash is the most critical of assets, yet cash has many problems associated with it. For one, cash has a tendency to get lost or stolen if left laying around; hence the need for a banking industry. (And the inclusion of the bank reconciliation problems in this chapter. Bank reconciliations are more of a bookkeeping function, and all this really involves is identifying the differences between the monthly bank statement balance and the balance in the company’s cash account. The majority of the differences are timing difference, i.e. outstanding checks, deposits in transits, unrecorded items or errors, e.g. a company issues a check on the 25th of the month and mails it to a vendor, and by the end of the month, the check is still outstanding (not cash), so while the Cash account reflects this check, the month end bank statement does not reflect this check being cash, same thing with deposits in transit, month end cash sales occur, but the cash is not deposited until the first day of the next month. But more significantly, cash in and of itself generates no income. In fact, cash loses value over time due to inflation in the economy. I think that it was John D. Rockefeller Links to an external site. (you know, the Standard Oil tycoon who went around handing out dimes to people) who said, “Money is like manure. You’ve got to spread it around for it to be useful. If you keep it in one spot, it just stinks." So it is with a company with excess cash. The funds must be invested in some assets for the company to earn a return. But that investment of funds is, by its very nature, a risky proposition. Here we are confronted with the classic financial tradeoff of risk versus return, or, liquidity versus profitability. No risk, no return. But high risk is no guarantee of the actualization of a high return. Instead, it is the expectation of a high return that entices an investor to assume a high level of risk. We will discuss this more we go over investments in the next week’s materials.
Liquidity can be measured in several ways, as we developed back in Chapter 5, when we discussed financial statement analysis. First, that measurement implies a classification of assets and liabilities into categories of current and long-term. Current assets are those that are expected to be used up in one operating cycle or one year. In order of liquidity, they are cash, marketable securities (what Bell calls short-term investments), accounts receivable, notes receivable, certain prepaid items, and inventories. Current liabilities include accounts payable, notes payable, accrued expenses, and the current portion of long-term debt, or CPLTD.
The first measure is an absolute dollar measure known as working capital. To compute, take the difference of current assets and liabilities. That is:
Current Assets - Current Liabilities = Working Capital
If current assets exceed current liabilities, then working capital is positive.
The current ratio is a relative measure of liquidity, and is expressed as the ratio of current assets to current liabilities. That is:
Current Assets/Current Liabilities = Current Ratio
So, for a company with current assets of $150,000 and current liabilities of $100,000, the company has $50,000 of working capital and a current ratio of 1.5:1.
Is the company liquid? Can it pay its bills? That depends on the composition of current assets and current liabilities. If the assets consists of $145,000 in inventory and the liabilities are all due tomorrow, the company doesn’t have much liquidity. Instead it has a problem, and that is the inventory that needs to be sold!
A third measure of liquidity is called the quick ratio, a comparison of a company’s assets that can quickly be converted to cash to its current liabilities. That ratio is computed as follows:
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities
As merchandisers invest their cash in inventory, they need to sell that inventory to generate cash. Back in the last unit on inventory, we introduced the idea of quantifying the speed at which inventory gets sold (and converted to cash) by measuring inventory turn, or days of sales of inventory. Those measures were calculated and interpreted as follows:
Inventory Turn is measured as: Cost of Goods Sold/Average Inventory; where average inventory is calculated as (Beginning Inventory + Ending Inventory)/2. The more rapid the inventory turn, the greater a company’s liquidity.
Days of Inventory is calculated as (Average Inventory/Cost of Goods Sold) x 365; the fewer days of inventory on hand, the less risk of shrinkage, the lower operating costs associated with inventory, such as insurance and handling.
We can compute similar measures for companies that sell on credit, that is, companies that generate accounts receivable:
Accounts Receivable Turn is measured as: Sales/Average Accounts Receivable; where average inventory is calculated as (Beginning Accounts Receivable + Ending Accounts Receivable)/2. The more rapid the accounts receivable turn, the quicker a company is collecting the funds due from customers and the greater a company’s liquidity.
Days Accounts Receivable Outstanding is calculated as (Average
Accounts Receivable /Sales) x 365; the fewer days accounts receivable remain uncollected, the less risk of bad debt losses, and, again, the quicker the company gets its cash.
In order to evaluate a company’s liquidity, it is important to take all the measures into account, and then to compare those measures to some benchmarks, such as industry standards or to prior periods’ results for the same companies. There may be very valid reasons for a company to vary from competitors, and sometimes variances that appear negative at first glance may indicate either management’s risk preferences, responses to specific market conditions, or other factors. As with all financial measures, “horse sense” and personal experience should play roles in analysis and decision-making.
Clifford