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IFT Notes for Level I CFA® Program

LM05 Working Capital & Liquidity

Part 2


4. Liquidity And Short-Term Funding

Liquidity is the extent to which a company is able to meet its short-term obligations using cash flows and those assets that can be readily transformed into cash.

The liquidity of an asset can be evaluated along two dimensions:

  • The type of the asset
  • The speed at which the asset can be converted into cash (by sale or financing)

Liquidity management refers to the company’s ability to generate cash when needed, at the lowest possible cost.

Two sources of liquidity for a company are:

  • primary sources of liquidity, such as cash balances
  • secondary sources of liquidity, such as selling assets

The main difference between the two is that using primary sources has no effect on the operations of a company while using secondary sources may negatively impact a company’s financial position.

Primary Sources of Liquidity

They represent the most readily accessible resources available to the company. Primary sources include:

  • Free cash flow: The firm’s after-tax operating cash flow less planned short- and long-term investments.
  • Ready cash balances: Cash available in bank accounts.
  • Short-term funds: Include items such as trade credit, bank lines of credit, and short-term investment portfolios.
  • Cash management: Refers to the company’s effectiveness in its cash management system and practices, and the degree of decentralization of the collections/payments processes. The higher the degree of decentralization, the more the cash tied up in the system.

Secondary Sources of Liquidity

Secondary sources include:

  • negotiating debt contracts
  • liquidating assets
  • filing for bankruptcy protection and reorganization

Example: Estimating Costs of Liquidity

(This is based on Example 5 from the curriculum.)

A company facing a liquidity crisis has the following options to raise funds. The estimated fair value and liquidation costs for each source of funds is listed below:

Source of Funds Fair Value (C$, millions) Liquidation Costs (%)
Sell short-term marketable securities 10 0
Sell select inventories and receivables 20 10
Sell excess real estate property 50 15
Sell a subsidiary of the firm 30 20

Net of liquidation costs, how much liquidity can the company raise if all four sources of funds are used?

Solution:

The costs and net funds raised are summarized in this table:

Source of Funds Fair Value (C$, millions) Liquidation Costs (%) Liquidation Costs (C$, millions) Net Proceeds (C$, millions)
Marketable securities 10 0 0 10
Inventories and receivables 20 10 2 18
Real estate property 50 15 7.5 42.5
Subsidiary of the firm 30 20 6 24
Total 15.5 94.5

Drags and Pulls on Liquidity

A company’s liquidity position is affected by cash receipts and the amount of cash it has to pay.

Drags on liquidity reduce cash inflows. For example, uncollected receivables, obsolete inventory, tight credit etc.

Pulls on liquidity accelerate cash outflows. For example, earlier payment of vendor dues, reduced credit limits (by suppliers), limits on short-term lines of credit (by banks) etc.

5. Measuring Liquidity

Liquidity contributes to a company’s credit-worthiness. Credit-worthiness is the perceived ability of the borrower to pay what is owed in a timely manner, despite adverse conditions.

High credit-worthiness allows a company to:

  • Obtain lower borrowing costs.
  • Obtain better terms for trade credit.
  • Have greater flexibility.
  • Exploit profitable opportunities, as the company can raise money relatively quickly to invest in profitable projects.

Ratios used for assessing a company’s liquidity

Financial ratios can be used to assess a company’s liquidity as well as its management of assets over time. The commonly used ratios are:

Liquidity Ratios
Ratio Formula Interpretation
Current ratio Current assets ÷ Current liabilities The greater the current ratio the higher the company’s liquidity
Quick ratio (Cash + Marketable securities + Receivables) ÷ Current liabilities The higher the quick ratio the higher the company’s liquidity
Cash ratio (Cash + Marketable securities) ÷ Current liabilities The higher the cash ratio the higher the company’s liquidity
Activity Ratios
Receivable turnover Credit Sales ÷  Average receivables It is a measure of how many times, on average, accounts receivable are created by credit sales and collected on during the fiscal period.
Number of days of receivables 365 or days in period ÷ Receivable turnover It tells the number of days on average the company takes to collect on the credit accounts
Inventory turnover Cost of goods sold ÷ Average inventory It is a measure of how many times, on average, inventory is created or acquired and sold during the fiscal period
Number of days of inventory 365 or days in the period ÷ Inventory turnover It is the length of time, on average, that the inventory remains within the company
Payables turnover Average day’s purchases ÷ Average trade payables It is a measure of how long it takes the company to pay its own suppliers
Number of days of payables 365 or days in the period ÷ Payables turnover It tells the number of days on average the company takes to make payments to its suppliers.
Cash conversion cycle Days of inventory + Days of receivables – Days of payables It measures the time from paying suppliers for raw materials to collecting cash from customers. The shorter the cycle, the better is the cash-generating ability of a company

Liquidity ratios are used to measure a company’s ability to meet its short-term obligations.

Activity ratios measure how well key current assets and working capital is managed over time.

The levels of these ratios, and their trends, or changes over time, in addition to comparisons with competitors or the industry, are used to judge a firm’s liquidity position.

6. Evaluating Short-Term Financing Choices

Since many short-term financing alternatives are available, a company should evaluate these options and create a planned borrowing strategy that will maximize its cost savings.

Companies seek to implement a short-term financing strategy that will help achieve the following objectives:

  • Ensure sufficient capacity to handle peak cash needs.
  • Maintain sufficient and diversified sources of credit.
  • Ensure rates are cost-effective.
  • Ensure both implicit and explicit funding costs are considered.

Factors that will influence a company’s short-term borrowing strategies are:

  • Size and creditworthiness: Larger companies have additional and cheaper options as compared to smaller companies. The borrower’s creditworthiness determines the access to and the cost of borrowing.
  • Legal and regulatory considerations: Legal and regulatory constraints on specific industries can restrict how much a company can borrow and under what terms.
  • Asset nature: Depending on their business model, some companies may have assets that are considered attractive as collateral for secured loans.
  • Flexibility of financing options: Flexibility allows a company to better manage its debt maturities. Cash budgeting exercises can help businesses avoid issues when credit markets are tight and a company’s ability to roll a particular maturity is limited.

Example: Meeting Short-Term Financing Need

(This is Example 9 from the curriculum.)

Keown Corp. has accounts payable of C$2 million with terms of 2/10, net 30. Accounts receivable also stands at C$2 million. In addition, the company has C$5 million in marketable securities. Keown has a short-term need of C$200,000 to meet payroll. Which of the following options makes the most sense for raising the C$200,000?

A. The company should issue long-term debt.

B. The company should issue common stock.

C. The company should delay paying accounts payable and forgo the 2% discount.

D. The company should sell some of its accounts receivable to a factor at a 10% discount.

E. The company should sell some of its marketable securities at a 0.5% brokerage cost.

Solution

A and B would not be appropriate for raising C$200,000 for a short-term need. These options take time to arrange, and they are more appropriate for long-term capital needs and for much larger financing amounts.

C, D, and E are all appropriate options for meeting short-term financing needs. However, C and D are costly.

The options for raising C$200,000 are summarized in this table:

    Liquidation Costs
Source of Funds Action % C$
C. Accounts payable (2/10, net 30) Delay C$200,000 in payment and forgo 2% discount 2.0 4,000
D. Accounts receivable Sell C$222,222 in value at 10% discount to raise CA$200,000 10.0 22,222
E. Marketable securities Sell C$200,000 in value 0.5 1,000

Choosing C means forgoing a 2% discount, which on C$ 200,000 amounts to a cost of C$4,000. To net C$200,000 using option D, the company would have to sell C$222,222 of accounts receivable to a factor, representing a cost of C$22,222. E appears to be the best choice. Marketable securities are liquid and can be easily sold for market value, less the relatively minor brokerage cost of C$1,000.


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