Preparing for CFA?

Practice tests, mock exams and readings with performance analytics. More Info

Home
AlphaBetaPrep.com
Sign In

Managing and measuring liquidity

Liquidity refers to the ability of a company to satisfy its short-term obligations using assets that can be readily converted to cash. Liquidity depends on both the type of asset and the speed at which it can be converted to cash. Liquidity management refers to how a company balances its short-term liabilities with short-term assets. Even though long-term assets may also be converted to cash to improve liquidity, it has other costs for a company, for example, it may impair a company’s financial strength.

Primary vs secondary sources of liquidity

Primary sources of cash include ready cash balances, short-term funds (such as trade credit, bank lines of credit, etc.), and cash flow management (i.e. the level of decentralization, because decentralized cash management means more cash will be tied up). Secondary sources of liquidity differ from the primary sources in that using a primary source does not affect normal operations of a company but using a secondary source does. Secondary sources include renegotiation of debt contracts (to switch to low-interest loans), liquidating assets (selling them), and filling for bankruptcy.

Drag vs pull on liquidity

A drag on liquidity refers to delay in receipts while a pull on liquidity refers to an acceleration in disbursements. Drags include uncollected receivables (which may be bad debts), obsolete inventory, tight credit (which makes short-term credit more expensive). Drags may be alleviated by stricter enforcement of credit. Pulls include early payments to vendors, reduced credit limits, limits on short-term lines of credit, and low liquidity positions (due to the company’s industry).

Measuring liquidity

Liquidity is a measure of a company’s creditworthiness because it affects solvency and its ability to obtain capital at low borrowing costs and exploit profitable opportunities.

A company’s liquidity primarily depends on the balance between its current assets and current liabilities, which is measured using the current ratio and quick ratio.

Current ratio

Current ratio equals current assets divided by current liabilities. A higher current ratio is better, but it also depends on its trend, its comparison with ratios of competitors and the availability of profitable opportunity in long-term assets.

$$ Current\ Ratio=\frac{Current\ Assets}{Current\ Liabilities} $$

Quick ratio

Quick ratio (also called acid-test ratio) equals quick assets (cash, short-term marketable securities and receivables) divided by current liabilities.

Liquidity depends on how quickly a company converts its inventories to sales/receivables, its receivables to cash and how delayed its payments to accounts payable become due.

Inventory turnover ratio

Inventory turnover ratio measures the number of takes inventories are sold. The number of days of inventories (also called average inventory period) measures how long it takes inventories to be sold.

$$ Inventory\ Turnover\ Ratio=\frac{Cost\ of\ Goods\ Sold\ (COGS)}{Average\ Inventory} $$

$$ Number\ of\ days\ of\ inventories\ =\ \frac{Average\ Inventory}{Daily\ COGS}=\frac{Average\ Inventory}{COGS\ /\ 365}=\frac{365}{COGS\ /\ Average\ Inventory}=\frac{365}{Inventory\ Turnover} $$

Accounts receivable turnover

Accounts receivable turnover measures the number of times accounts receivables are created and collected. Days sales outstanding (also called days in receivables or number of days of receivables) measures the number of days it takes to collect cash from receivables on average.

$$ Accounts\ Receivable\ Turnover\ =\ \frac{Credit\ Sales}{Average\ Accounts\ Receivable} $$

$$ DSO\ =\ \frac{365}{Accounts\ Receivable\ Turnover} $$

Accounts receivable turnover and DSO must be analyzed keeping in view the credit terms and the relationship between sales and credit terms and industry practices.

Number of days of payables measure how long a company takes in paying its creditors.

$$ Number\ of\ days\ of\ payables\ =\ \frac{Average\ Accounts\ Payable}{Purchases\ /\ 365} $$

All these ratios make sense when they are compared across time and between different companies in the same industry. For example, a high inventory turnover may be due to efficient production or inventory shortages.

Operating cycle and cash conversion cycle

The operating cycle represent the number of days a company takes in selling its inventories and then receiving associated cash. It is the sum of the number of days of inventory and the number of days of receivables. Net operating cycle (also called cash conversion cycle) equals the operating cycle minus number of days of payable. In general, shorter cycles are better.

by Obaidullah Jan, ACA, CFA on Fri Feb 21 2020

This article can help you prepare for Reading 35 LOSa, LOS5b & LOS5c.

Access complete notes and question bank   Login with Google Login with Facebook


More Articles

Managing and measuring liquidity Investing short-term funds Managing short-term financing