Benchmarking System

Liquidity is defined as the ability to realize value in cash. It has two components:

 The convention time of an asset, that is, the time lag between deciding to sell an asset and receiving payment for it; and

  Its convention price.

Cash has zero conversion time and no conversion price risk. Marketable securities, providing they are actively traded, have zero conversion time but have significant conversion price risk associated with interest rate risk.

The optimal level of liquidity, that is, a level which is not too low so as to produce significant probabilities of financial distress and bankruptcy, and not too high so as to reduce the rate of return on long-term investment, is difficult to determine. As a rough guide a number of short-term financial ratios can be examined to determine if an optimal liquidity policy is being pursued. Beginning with cash and marketable securities ratios, these are:

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Cash + Marketable Securities

Current Assets and

Cash + Marketable Securities

Current Liabilities

Reasonably large values of the former indicate that cash and marketable securities can provide substantial sources of funds to finance any increases in current assets which might occur with increased sales.

Reasonably high levels of the latter measure the ability to meet current liabilities without the need to liquidate other current assets, for example inventory, or without recourse to external sources of finance.

It would be wrong, however, to determine the liquidity position of a company purely in cash ratio terms. As indicated, inventory can be sold directly for cash, but it may have a relatively long conversion time and have a conversion price which is significantly less than the inventory’s intrinsic value. The latter will occur especially if it is known that inventory is being offered for sale in a situation of financial distress.

Banks and financial institutions provide factoring services in respect of inventory and invoice discounting in respect of accounts receivable so as to eliminate conversion time. Here, a part or a whole of a company’s inventory and/or its accounts receivable are purchased by a factoring company which, consequently, provides an immediate infusion of cash.

Again, however, the conversion price will be below the intrinsic value of the current asset being purchased since factors earn their returns from obtaining assets at significant discounts and then reselling them or, in the case of accounts receivable, collecting payments due.

Two, more broadly based liquidity, measures take some of the above points into account. The first is the current ratio defined as:

Current Ratio = Current Assets Current Liabilities

This encompasses net working capital (current assets less current liabilities) and is a measure of a company’s capacity to meet its liabilities, due within one year, out of current assets. Because a substantial proportion of current assets includes inventory which, assuming factoring services are not used, has a positive conversion time and significant conversion price risk, a desirable level for this ratio is

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taken, on average, to be 2.1. The second liquidity measure is referred to as the Acid Test or Quick ratio. This ratio nets out the effect of inventory and is defined as:

Quick Ratio = Cash Assets - Inventory Current Liabilities

On average, its optimal level is considered to be 1:1.

These cash, current and quick ratios are unlikely to give a full picture of a company’s liquidity position. Back-up lines of credit which may not be explicitly observable can be important, for example, a bank’s willingness to provide it has placed on a company’s current account and a bank’s willingness to provide additional short-term loans at short notice. These factors will help to determine a company’s financing flexibility which, as explained in unit 11, partly depends on the levels of short-term and long-term tangible assets already pledged in existing loan contracts. Indeed the ability of a company to provide a near-term cash flow forecast, and the variability surrounding near-term cash flows, also play a part in determining the effect of liquidity on a company’s market value.

The above introduces a dynamic aspect to liquidity which is not normally picked up in static (at a point in time) short-term financial ratios. The dynamic aspect involves the speed with which a company can alter its short-term position to avoid a crisis. It has been argued that one possible way of accommodating this is by considering a ratio based on a company’s earnings power, that is, the ratio of:

Cash Liabilities – Quick Assets x 365

Operating Funds Expected to be Generated over a Year

This ratio gives the number of days required to pay off net current debt, that is, current debt not covered by liquid or quick assets. If, for example, this ratio exceeds 365 a company will be unable to meet its net current obligations out of its current year’s expected earnings. Alternatively, if the ratio is significantly below 365 and short-term difficulties arise. The indication may be that additional short-term finance will be obtainable since banks would view such funding as entailing low risk. Expected earnings over the current year are not., however, a substitute for a short-term cash flow forecast which provides better evidence of the ability to repay net current debt.

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