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:
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:
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.
They represent the most readily accessible resources available to the company. Primary sources include:
Secondary sources include:
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$, millions)||Liquidation Costs (%)|
|Sell short-term marketable securities||10||0|
|Sell select inventories and receivables||20||10|
|Sell excess real estate property||50||15|
|Sell a subsidiary of the firm||30||20|
Net of liquidation costs, how much liquidity can the company raise if all four sources of funds are used?
The costs and net funds raised are summarized in this table:
|Source of Funds||Fair Value (C$, millions)||Liquidation Costs (%)||Liquidation Costs (C$, millions)||Net Proceeds (C$, millions)|
|Inventories and receivables||20||10||2||18|
|Real estate property||50||15||7.5||42.5|
|Subsidiary of the firm||30||20||6||24|
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.
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:
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:
|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|
|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|
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.
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:
Factors that will influence a company’s short-term borrowing strategies are:
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.
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$200,000 are summarized in this table:
|Source of Funds||Action||%||C$|
|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.