Liquidity
Short-term liquidity measures
Money is the most important thing in the world. It represents health, strength, honour, generosity and beauty as conspicuously and undeniably as the want of it represents illness, weakness, disgrace, meanness and ugliness.
GEORGE BERNARD SHAW (1856–1950)
Short-term liquidity measures
The first test of a company’s financial position is, ‘Will it have sufficient cash over the immediate future to meet its short-term liabilities as they fall due?’ Unless the answer here is positive, the company is in a financial crisis irrespective of its profit performance.
Normally short-term liabilities amount to a considerable part of the total borrowings of the company. They are always greater than the company’s pure cash resources. The question we ask is, ‘Where will the cash come from to pay them?’
Cash is in constant movement through the company. It flows in daily from accounts receivable as customers pay their bills. Each payment reduces the balance outstanding, unless it is in turn topped up by transfers from the finished goods inventory as new sales are made. The finished goods inventory is likewise fed from raw materials and work in process. We can visualize these assets as temporary stores for cash, i.e., inventories in various forms and accounts receivable. These are the assets that collectively make up ‘current assets’. They amount to a high percentage of a company’s total investment.
At the same time, goods are being purchased on credit from suppliers, thereby creating short-term liabilities. Normally other short-term loans are being availed of also. It is these that we collectively refer to as ‘current liabilities’.
We measure a firm’s short-term liquidity position by comparing the values of ‘current assets’ with its ‘current liabilities’.
Three ways of expressing this relationship are illustrated:
- current ratio
- quick ratio
- ‘working capital to sales’ ratio.
We illustrate these measures in this chapter. In chapter 10 measures of long-term liquidity are discussed.
Current ratio
The current ratio is a favourite of the institutions that lend money. The calculation is based on a simple comparison between the totals of ‘current assets’ and ‘current liabilities’.
The former represent the amount of liquid, i.e., cash and near-cash, assets available to the business. The latter give an indication of its upcoming cash requirements. Institutions expect to see a positive cash surplus here. We therefore look for a value comfortably in excess of 1.0 for this ratio. While this is the standard for most types of businesses, certain types of operation are capable of operating at a much lower value.
In figure 9.1 we can see that the average for the US Consolidated Company Inc. in 2000 is 1.3 times. The ‘range of values’ chart for top UK companies shows that this ratio can go as high as 1.8 times, and that for a small percentage of companies it will fall below 1.0 times.
A word of caution is needed concerning the interpretation of this or any other ratio for a particular company. A wide diversity of conditions exist in different types of business. Some businesses are able to exist comfortably with liquidity ratios that would spell disaster for others. Some companies have to carry large stocks, have long production cycles, give long credit and so on, while other businesses carry almost no stock and receive more credit than they give.
One ratio value in isolation tells us little. To get a good picture of a situation we must use a series of tests and we must apply appropriate benchmarks. These benchmarks can be derived from many sources, such as historical data, competitors’ accounts and published data of all kinds.
It can be said regarding liquidity ratios, that it is the trend over time rather than the absolute value that gives the most valuable information. A current ratio of 1.2 could give either a good or bad signal depending on past results.
A disadvantage of this ratio is that it does not distinguish between different types of current assets, some of which are far more liquid than others. A company could be getting into cash problems and still have a strong current ratio. This issue is addressed in the next section.
Figure 9.1 Current ratio applied to data from (A) the US Consolidated Company Inc., (B) UK top companies, 2000
Quick ratio
The calculation here is very similiar to that of the ‘current ratio’. Simply remove the ‘inventories’ value from the ‘current assets’ and divide the result by the ‘current liabilities’ total.
The reason for excluding the inventory figure is that its liquidity can be a problem. You will recall that the term ‘liquidity’ is used to express how quickly, and to what percentage of its book value, an asset can be converted into cash if the need were to arise.
For instance, a cargo of crude oil in port at Rotterdam has a high liquidity value, whereas a stock of fashion garments in a warehouse probably has a low one.
We can meet with a situation where a company has a constant current but a falling quick ratio. This would be a most dangerous sign. It tells us that inventory is building up at the expense of receivables and cash.
Lending institutions have difficulty in ascertaining the liquidity of many types of inventory. They feel much more comfortable when dealing with receivables and cash. Accordingly they pay quite a lot of attention to the ‘quick ratio’.
Both the current and quick ratios are the most widely used measures of short-term liquidity but a problem with them is that they are static. They reflect values at a point in time only, i.e., at the balance sheet date. It is possible to ‘window dress’ a company’s accounts so that it looks good on this one day only. To deal with this shortcoming it is argued that cash flow over the short-term future would be a better indicator of ability to pay. The ‘working capital to sales’ ratio illustrated in figure 9.3 meets this objection to a certain extent.
Figure 9.2 shows an average value of 0.8 times with 50 per cent of companies falling within the range of 0.6 to 1.1 times. A value of 1.0 is very strong. It means that the company can pay off all its short-term liabilities from its cash balances plus its accounts receivable. Most companies decide that such a level of liquidity is unnecessary. An alternative name for this ratio is the ‘acid test’.
Figure 9.2 Quick ratio applied to data from (A) the US Consolidated Company Inc., (B) UK top companies, 2000
Working capital to sales ratio
The ratio illustrated in figure 9.3 gives us a glimpse of the liquidity position from yet another angle. This measure shows up some features that cannot be ascertained easily from the previous two measures.
In chapter 3, working capital was defined as ‘current assets’ less ‘current liabilities’. We express this value as a percentage of ‘sales’.
Whereas the current and quick ratios use balance sheets figures only, here we take into account the ongoing operations by including a value from the profit and loss account. The ‘sales’ figure reflects, to some extent, the operating cash flow through the whole system. This ratio, therefore, relates the short-term surplus liquidity to the annual operating cash flow.
It will often highlight a trend the other ratios miss. It is possible to have a stable ‘current’ or ‘quick’ ratio while this ratio is falling. This would happen if sales were increasing rapidly but levels of working capital were static. A condition known as ‘overtrading’ could develop.
The term ‘overtrading’ is used to describe a situation where there are not sufficient resources in the balance sheet to carry the level of existing business. It arises in a company that has grown too fast or has been underfunded in the first place. The symptoms show up as a constant shortage of cash to meet day-to-day needs. There is a danger of bankruptcy. Probably the only solution to the condition is an injection of long-term liquid funds.
There is a difference between being short of ‘working capital’ and so managing the business that less ‘working capital’ is needed. The latter is a sign of good management. The modern trend is towards a lower ‘working capital to sales’ ratio, particularly in the form of much reduced inventories.
We can see from figure 9.3 that the average value for the US Consolidated Company Inc. is 7 per cent. Research in 2000 on top UK companies suggested values of between 10 and 21 per cent.
Figure 9.3 Working capital to sales ratio applied to data from (A) the US Consolidated Company Inc., (B) UK top companies, 2000
Working capital days
Possibly the clearest way of looking at the role of working capital in a company’s operations is illustrated in figure 9.4.
Data have been extracted from accounts of the US Consolidated Company Inc. for ‘inventory’, ‘accounts receivable’ and ‘accounts payable’. The significance of these accounts is that they are ‘spontaneous’. They react very quickly to changes in levels of company turnover. The company will have policies regarding levels of inventory, etc., but these policies will not fix absolute values, they will be expressed in terms of sales. A sustained growth in sales will inevitably result in growth in these three accounts.
We express each account in terms of ‘days’ sales’ (see figure 7.5), i.e.:
| Amount | Days | |
|---|---|---|
| Inventory | $86.6 (bn) | 44 |
| Accounts receivable | $68.2 | 34 |
| Accounts payable | $56.1 | 28 |
The data are plotted in figure 9.4. The objective is to show the number of days that lapse from the time money is paid out to the suppliers of materials until the corresponding cash is received back from the customer that buys the goods.
We nominate day 0 to indicate when goods are received from suppliers. Given the average stockholding period, day 44 indicates when the goods are sold. The customer takes on average 34 days to pay, so cash is received on day 78.
In the meantime the company, given its average number of days credit, will have paid the supplier on day 28. The time gap between the cash out on day 28 and its return to the company on day 78 is 50 days. (In addition the company will have paid out in respect of wages, salaries and overheads all through the period.)
It is this time gap that creates in a company the need for working capital. The amount is easily quantified. Given a gap of 50 days, each $1m of sales requires ‘about’ $136,000 ($1m × 50/365) of working capital. Every increase of $1m will create a need for an additional $136,000 in cash resources. This point is often missed by small rapidly growing companies who find themselves in cash difficulties in the midst of high sales and profits.
Figure 9.4 Working capital days for US Consolidated Company Inc.
