This is the first in a three-part series on how to measure company liquidity. Part two and three can be found here:
In the spring of 2011, Borders Group Inc, known for its 10,000 plus retail book stores, filed for Chapter 11 bankruptcy, effectively ending its 40 years life in the book selling business.
After negations to keep the company operating failed, Borders declared bankruptcy and the courts took over. Liquidation companies, who specialize in purchasing distressed company assets, acquired and resold much of Borders stores, merchandise, and other assets of value.
This could be among the worst case scenarios for a company, but every investor needs to know how liquid a company’s assets are. If a company had to sell everything it owned to pay its creditors, which is what happened to Borders, how would they do this? What is considered valuable? Can we see the difference between a liquid and illiquid company…and why is this important? In this article series, we will demonstrate how to perform a liquidity analysis, but we will occasionally break off to discuss topics like these.
Liquidity: A basic explanation
At its essence, liquidity measures how quickly various company assets can be converted to cash. Investors, lenders and regulators analyze liquidity of a given organization in order to determine how well it can meet its obligations. Liquidity is a fundamental step in company analysis as it shows the company’s ability to manage its current assets and liabilities and influences its ability to obtain financing. The better equipped the organization is to obtain financing, the better its prospects for growth.
A commonly accepted number of liquidity ratios are used in conducting a liquidity analysis, but these financial ratios should not be taken at face value. Companies operating in different industries can have vastly different liquidity levels: what is normal for one industry is not necessarily normal for another, as in “Company A”:
Can we compare these two companies shown above? If they are not operating within the same industry or line of business, not likely. Thus, it’s important to understand the industry and its trends before making conclusions. Frequently, a more extensive analysis is required in the assessment of a company’s overall financial health, but analyzing the liquidity is a good first step.
Why look at Liquidity?
Liquidity needs to be looked at from two perspectives; from inside the company and from the point of view of an investor. Fortunately, both perspectives converge on the same thing : can this company sell its assets to pay its creditors if such time arises?
Just as many companies create procedures and policies to continue business operations in case of physical catastrophes like natural disasters and theft, they need to be prepared to liquidate some or all of their assets. As happened to Borders, companies need to make sure they have assets set aside for unexpected expenses and adverse market conditions that may reduce or eliminate revenue from their daily operations. A “plan B” would be to keep assets in reserve where a company could liquidate or sell in times of stress. Savvy financial managers ideally structure these assets so they are (1) relatively easy to access if needed, and (2) can produce revenue on their own. Securities, bonds, t-bills, among others are examples of assets companies park their “rainy-day” funds.
Proceed to part two in the liquidity series: How to Measure Liquidity, Part 2