Liquidity

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.

Liquidity management describes a company’s ability to generate cash whenever it needs to meet its short-term obligations. Sources of liquidity vary from one company to another but can be generally classified as either primary or secondary sources.

Primary 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:

• Cash and marketable securities on hand – This refers to cash in the bank accounts or held as currency, and securities that can be quickly converted into cash without any significant loss of value.
• Borrowings: These consist of a company’s short-term investment portfolios, trade credit, and bank lines of credit. In as much as cash from borrowings can help settle near-term obligations, they must be repaid.
• Cash flow from the business – This refers to cash generated by the business, and is substantial only for profitable firms.

Cash flow from the business is the primary long-term source of liquidity for a firm, and analysts track cash flows from the business using the statement of cash flows.

Analysts can calculate teh following cash flow measures from the statement of cash flows.

1. Cash flow from operations: It measures an issuer’s primary business activities’ cash profit over time, calculated as follows.Cash received from customers.

   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

2. Free cash flow: Cash flow from operations does not account for the issuer’s capital investments to expand or improve operations. Thus, we calculate free cash flow to account for this.

Cash flows from operations

Minus: Investments in long-term assets

Free cash flow

Secondary Sources of Liquidity

Secondary sources of liquidity include:

• Renegotiating debt contracts to reduce high-interest payments or principal repayment burdens.
• Selling assets.
• Reducing or suspending shareholders’ dividends.
• Delaying or reducing capital expenditures.
• Issuing equity through share issuance in private or public markets. The effect is that the existing shareholders’ equity will be diluted.
• Filing for bankruptcy protection and reorganization.

Using secondary sources of liquidity signals that a company’s financial health is deteriorating as it is willing to raise capital at a higher cost or at a disadvantage to its existing stakeholders.

Factors affecting Liquidity: Drags and Pulls

Drag on Liquidity

The timing of cash receipts and disbursements can significantly affect a company’s liquidity position. When receipts infrequently occur i.e., cash inflows lag, especially after payments are made, a ‘drag on liquidity’ occurs due to the decreased availability of funds. Drags on liquidity include:

1. Uncollected receivables.
2. Obsolete inventory.
3. Borrowing constraints.

Pull on Liquidity

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:

• Early payments.
• Reduced credit limits.
• Limits on short-term lines of credit.
• Low liquidity positions.

Measuring and Evaluating Liquidity

A company’s liquidity determines its creditworthiness and capacity to borrow at cheaper rates and with better credit conditions. The less liquid a company is, the more likely it will go bankrupt.

Analysts use liquidity and activity ratios to compare the liquidity of firms with different sizes and varying sources of liquidity. Liquidity ratios measure a firm’s ability to satisfy its short-term obligations using its current assets. We will discuss below the three major liquidity ratios that analysts use.

Current Ratio

A company with a positive total working capital (Working capital = Current assets – Current liabilities) will likely have a current ratio greater than one. A higher current ratio implies greater liquidity under this measure.

$$ \text{Current ratio}=\frac{\text{Current assets}}{\text{Current liabilities}} $$

Quick Ratio

The quick ratio removes inventory (compared to other current assets, inventory and receivables are less readily convertibel to cash) 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.

$$
\text{Quick ratio}=\frac{\text{Cash}+\text{Short term marketable instruments}+\text{Receivables}}{\text{Current liabilities}} $$

Cash Ratio

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?

1. Negotiating debt contracts and liquidating assets.
2. Ready cash balances and short-term funds.
3. 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.