Level 1 CFA® Exam:
In this lesson, we’re going to say what liquidity is and what its sources are. We’re also going to show you how we can measure liquidity – that is, we’re going to talk about basic liquidity ratios.
Let's start by defining liquidity and liquidity management.
A company's liquidity is the ability to meet its short-term obligations using assets converted to cash. There is a couple of things you should pay attention to in this definition.
First, we must distinguish liquidity from solvency. Solvency is the company's ability to fulfill long-term obligations. In contrast, liquidity is the ability to meet the company's short-term obligations such as money owed to suppliers.
Secondly, although it may seem that solvency is more important than liquidity, lack of either can lead to bankruptcy. If a company has low liquidity, it has a problem with covering its short-term obligations on time, and this may very quickly lead to bankruptcy.
Thirdly, the liquidity of a company is primarily affected by the size of:
- short-term assets, and
- short-term liabilities.
Generally, the higher the ratios of short-term assets (such as inventory, cash, or receivables) to current liabilities, the higher the liquidity and the better the position of the company.
At the same time, you should note one more thing. Apart from liquidity as such, liquidity management is equally important. Liquidity management is about the company’s ability to generate cash at a time when it is needed. The point is that too high liquidity may indicate inefficient use of assets and be unfavorable from the point of view of the company and its owners. And too low liquidity may result in the company going bankrupt.
Now let’s think about how the company’s liquidity affects cash flows. We can distinguish between drags and pulls on liquidity. A drag on liquidity is when there are delays on cash inflows, for example, money from business partners comes with a delay. So, a drag on liquidity lowers the available resources. A pull on liquidity is when disbursements are paid too quickly, that is when for example the company settles liabilities to suppliers too quickly.
The main drags on liquidity are:
- uncollected receivables – the more they are delayed, the greater the chance that they won’t be fully collected,
- obsolete inventory – the longer they are not used, the greater the chance that you won’t sell them at all,
- tight credit – if the economic situation is difficult, short-term debt becomes expensive and difficult to get from the bank.
The main pulls on liquidity include:
As we know, liquidity affects the company’s creditworthiness, namely the ability to repay the debt within the required time. Companies with high levels of liquidity obtain lower interest rates on loans because the risk for the bank is lower. However, the lower the liquidity, the higher the risk for the bank and the higher interest rates on loans. To measure the level of liquidity, we can use:
- current ratio, and
- quick ratio.
Generally, the rule is that the higher these ratios are, the higher the liquidity. But you must be careful when drawing conclusions about the ratios:
Another group of ratios that we’re going to learn about are the ones that tell us about how individual components of current assets are managed. These ratios include:
- accounts receivable turnover,
- number of days of receivables,
- inventory turnover,
- number of days of inventory,
- accounts payable turnover,
- number of days of payables,
- operating cycle,
- net operating cycle (aka. cash conversion cycle).
Accounts receivable turnover is equal to credit sales divided by average receivables. This ratio shows how many times per year on average the company collects receivables.
The number of days of receivables equals accounts receivable divided by sales on credit divided by 365 days. This ratio shows how much time we have to wait for receivables to be paid.
Inventory turnover is equal to the (cost of goods sold) divided by the average inventory. Inventory turnover shows us how many times a year inventory is created and sold.
The number of days of inventory is equal to inventory divided by the (cost of goods sold) divided by 365 days. This ratio tells you how many days on average inventory remains in the company. The time varies depending on the type of business.
The number of days of payables is equal to accounts payable divided by purchases divided by 365. This ratio tells within how many days the company pays its suppliers.
We can juxtapose these ratios to form yet another group of ratios, namely:
- the operating cycle, and
- the net operating cycle.
The operating cycle is equal to the number of days of inventory plus the number of days of receivables. It measures the time needed to convert raw materials into cash obtained from the sale of finished products.
The net operating cycle is equal to the number of days of inventory plus the number of days of receivables minus the number of days of payables.
The net operating cycle, is also known as the cash conversion cycle and measures the time from paying suppliers for materials to collecting cash from the sale of goods produced from these supplies.
The net operating cycle is equal to the operating cycle minus the number of days of payables.
Generally, the lower these two ratios are, the better. A lower net operating cycle ratio means that the company needs fewer days to recover money spent on materials.
- A company's liquidity is the ability to meet its short-term obligations using assets converted to cash.
- Solvency is the company's ability to fulfill long-term obligations.
- Liquidity management is about the company’s ability to generate cash at a time when it is needed.
- The use of primary sources of liquidity doesn’t affect the normal operations of the company, while the use of secondary sources of liquidity affects both the company’s operational and financial situation.
- A drag on liquidity is when there are delays in cash inflows.
- A pull on liquidity is when disbursements are paid too quickly.
- To measure the level of liquidity, we can use liquidity ratios, for example, current ratio or quick ratio.
- Activity ratios tell us about how individual components of current assets are managed.
- The net operating cycle, is also known as the cash conversion cycle and measures the time from paying suppliers for materials to collecting cash from the sale of goods produced from these supplies.