This is the second article in a three-part series on how to measure company liquidity. Part 1 and part 3 can be found here:
As we have explained the importance and reasons for measuring liquidity, we can now dive headfirst into the details of how to measure liquidity. A general liquidity analysis is generally conducted with liquidity ratios. These ratios are vital, as they use data values reported by a company from their financial statements. There is no room for embellishments or opinions in the match, just hard numbers.
We discussed in part one of this article series the liquidity issues Borders Group Inc faced during their bankruptcy. In their last months of operations with bankruptcy looming, they were likely pouring over their operations reports, inventory reports, and financial statements trying to answer questions like:
Can we pay our debt to our creditors and avoid bankruptcy?
If bankruptcy is unavoidable, to whom do we owe, and how much?
What assets do we have available we could liquidate to repay our creditors?
Will the shareholders receive any compensation if the company is liquidated?
Although Borders may have used calculations specific to book merchant, here are key liquidity ratios nearly every company could use to establish their liquidity.
The Current Ratio
The Current Ratio is the ratio of current assets to current liabilities. It demonstrates an organization’s ability to cover its short-term obligations and is a simple way to measure liquidity, but it can be deceiving because it is based on a broad definition of current assets. Specific industries will have more-defined values for their current assets. Naturally, the higher the ratio, the higher the level of liquidity. Healthy firms display current ratios higher than 1.0.
The Quick Ratio
The Quick Ratio is the ratio of the sum of cash, marketable securities and accounts receivable to current liabilities. It is more conservative than the current ratio as it does not account for certain current assets.
The Cash Ratio
The Cash Ratio is the ratio of cash and
marketable securities to current liabilities and is the most conservative of the three main liquidity ratios. It only takes into account cash and short-term securities, thus showing the true level of liquidity of a given firm.
The Basic Defense Interval
The Basic Defense Interval, also called
the Defensive Interval, is the ratio of cash, marketable securities and receivables to daily cash expenses. Daily cash expenses can vary by industry, but they are usually operating expenses, interest expenses, and income tax. BDI shows how many days worth of expenses an organization can cover with its current assets, without any additional income coming in. This ratio is especially useful when the analysis is done in light of an economic downturn or when a seasonal business is being analyzed.
The Inventory Turnover Ratio
The Inventory Turnover ratio is found
by dividing the cost of goods sold by the average inventory figure. It shows how many times the organization sold its inventory during a given year. A low inventory turnover figure indicates that the inventory is not being moved frequently, which could signal liquidity problems. A high ratio is not always a positive sign either, as it could indicate that the company is not using its assets effectively.
Just a value and not a ratio, Working Capital is found by subtracting total current liabilities from total current assets and indicates how much money would be left if the company liquidated its current assets to pay off its short-term obligations.
The Accounts Receivable Turnover Ratio
Accounts receivable turnover ratio is
calculated by dividing net sales by average gross receivables. This ratio indicates how many times the firm collects on its receivables during a given fiscal year. The higher the ratio, the more effectively the firm lends credit to customers. A lower ratio means that while the company made sales, it did not receive what it is owed. This may cause liquidity problems in the future.
These ratios can be calculated either based on averages or based on ending values. More often than not, the ending values are used for calculations because they display a company’s financial position at certain point in time. When the same analysis is done over several periods, such as the last four quarters or a number of years, what was just a snapshot of the company operating conditions becomes a dynamic and flowing series of events, and is where the true value of a deep ratio analysis lies.
Activity versus liquidity ratios
Some of the ratios we recommend in a liquidity analysis are not pure liquidity ratios, but also activity ratios; pure liquidity ratios deal with strictly current assets and current liabilities. The immediate liquidity levels and value of the company are reviewed. Activity ratios deal with more long term items such as receivables and inventories. Although receivables and inventories are considered assets, both are more difficult to convert into real cash. There tends to be a percentage of receivables that are never paid to the company and inventory can spoil, become damaged, lost, stolen, or simply lose value over time.
In the final part of this series, we look at the Boeing company, using their financial statements as a test of our liquidity ratios and attempt to summarize their liquidity levels.