Mechanisms to Manage Stakeholder Relat ...
Liquidity is the degree to which a corporation can satisfy its short-term obligations using cash flows and assets that can be quickly converted into cash. In this context, liquidity refers to the available cash, borrowing power, and ability to turn other assets into cash.
Liquidity management describes a company’s ability to generate cash whenever it needs to meet its short-term obligations. Effective liquidity management means that a company can manage its significant sources of liquidity efficiently. Although these sources of liquidity tend to vary from one company to another, they include primary and secondary sources of liquidity.
Primary liquidity sources refer to funds readily accessible to a company at a relatively low cost. They can be held as cash or cash equivalents, and they include the following:
Primary sources of liquidity demonstrate how well an organization’s cash management processes are working. Analysts track an issuer’s cash flow information using the statement of cash flows. Analysts can calculate cash flow measures from the statement of cash flows.
Plus: Interest and dividends received on financial investments
Minus: Cash paid to employees and suppliers
Minus: Taxes paid to governments
Minus: Interest paid to lenders
Cash flows from operations
Cash flows from operations
Minus: Investments in long-term assets
Free cash flow
Secondary sources of liquidity include:
Using secondary sources of liquidity can impact a company’s financial and operating positions. In this respect, secondary liquidation sources are unlike primary sources of liquidity, which usually have no such impact. Using secondary sources of liquidity can also signal that a company’s financial health is worsening. Consequently, under such circumstances, liquidity is provided at a higher cost than usual.
The timing of cash receipts and disbursements can significantly affect a company’s liquidity position. When receipts infrequently occur, especially after payments are made, a ‘drag on liquidity’ occurs due to the decreased availability of funds. Drags on liquidity include:
A ‘pull-on liquidity’ occurs when disbursements are paid too early. This is because companies will be forced to spend money before receiving funds from sales. Pulls on liquidity include:
A company’s liquidity determines its creditworthiness and capacity to borrow at cheaper rates and with better credit conditions, increasing its flexibility. The less liquid a company is, the more likely a corporation will go bankrupt.
The liquidity of a corporation may be evaluated using the following financial ratios:
Liquidity ratios assist in measuring the ability of a company to satisfy short-term obligations when they fall due. Comparing a company’s liquidity ratios with those of peer companies in the same industry can determine the relative creditworthiness of the company.
Common liquidity ratios include:
A company with a positive total working capital will likely have a current ratio greater than one. A higher current ratio implies greater liquidity under this measure, including short-term assets.
$$ \text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}} $$
The quick ratio removes inventory since it is not easy to convert to cash. A firm that can meet its short-term cash obligations without liquidating inventory will likely have a quick ratio greater than one.
$$
\text{Quick ratio}=\frac{\text{Cash}+\text{Short term marketable instruments}+\text{Receivables}}{\text{Current liabilities}} $$
The cash ratio compares short-term marketable securities and cash with current liabilities. A cash ratio greater than or equal to one indicates that a firm could meet all its short-term obligations without collecting receivables or waiting to sell inventory.
$$ \text{Cash ratio}=\frac{\text{Cash}+\text{Short term marketable instruments}}{\text{Current liabilities}} $$
Example: Calculating Liquidity Ratios
$$ \text{Consider the following balance sheet for Company ABC (in } \$ \text{ million):} $$
$$ \begin{array}{l|r}
\text{Cash} & 150 \\
\text{Short-term marketable securities} & 400 \\
\text{Accounts receivable} & 500 \\
\text{Inventory} & 900 \\
\text{Prepaid expenses} & 600 \\
\text{PPE} & 20,000 \\ \hline
\text{Total Assets} & 22,550 \\ \\
\text{Accounts payable:} & 600 \\
\text{Accrued expenses} & 80 \\
\text{Short-term debt} & 1,200 \\ \hline
\text{Total liabilities} & 1,880
\end{array} $$
Calculate the current ratio, quick ratio, and cash ratio.
Solution
$$ \text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}}=\frac{2,550}{1,880}=1.36 $$
$$ \begin{align*} \text{Quick ratio} & =\frac{\text{Cash}+\text{Short term marketable instruments}+\text{Receivables}}{\text{Current liabilities}} \\ & =\frac{150+400+500}{1,880}=0.56 \end{align*} $$
$$ \begin{align*}
\text{Cash ratio} & =\frac{\text{Cash}+\text{Short term marketable instruments}}{\text{Current liabilities}} \\ & =\frac{150+400}{1,880}=0.29
\end{align*} $$
Question
Which of the following are most likely primary sources of liquidity?
- Negotiating debt contracts and liquidating assets.
- Ready cash balances and short-term funds.
- Filing for bankruptcy and cash flow management.
Solution
The correct answer is B.
Readily available cash balances and short-term funds are examples of primary sources of liquidity.
A is incorrect. Negotiating debt contracts and liquidating assets are examples of secondary sources of liquidity.
C is incorrect. Whereas cash flow management is a primary source of liquidity, filing bankruptcy is a secondary source of liquidity.