Liquidity Ratios
Liquidity is a company’s ability to quickly convert assets into cash, to pay off short-term liabilities, or obligations without raising money 3rd-parties. The emphasis on liquidity is the short-term!
Liquidity Ratios only concern the “Current” parts of a balance sheet. See below
Companies need “liquidity” to cover their short-term liabilities and obligations. If a company can’t meet short-term liabilities (e.g, paying staff, operational bills or repaying loan) they may face bankruptcy – even if they would be able to pay the money they owed in a later period.
You may be wondering: What do you mean… How can a company only be able to pay for some items in a later period but now today? Let me use an example:
On Day 0, Charlie has cash buying $100 of Inventory. On Day 1, Charlie Sells the Inventory (biscuits) to a supermarket and agrees to be paid in 30 days… The problem is Charlie needs to pay his staff every two weeks!
As you can see, Charlie’s money is “tied up” in Accounts Receivable which will convert to cash on Day 30, but he needs to pay his staff on Day 15 (and again on Day 30). Charlie has a liquidity problem!
If Charlie could wait till Day 30 to pay his staff there would be no issue but payroll is goes out every two weeks. From the sale, he is making $30 in profit, and recouping the $100 he spent on buying raw materials to make inventory – more than enough to pay his staff’s wages of $10 every two weeks. He would need to take on a short-term loan to cover his cash shortfall on Day 15 and repay it on Day 30 when he receives payment or face a bankruptcy process.
There is no fundamental problem with his business, however, there is a mismatch between the timing of when his assets generate cash and when his liabilities must be paid – in finance terms, we call this an asset-liability mismatch.
A common phrase in finance would describe Charlie as asset rich, but cash poor.
You may think that one could easily take a loan from the bank to cover the cash shortfall. While you are probably right, a phrase that was taught to me rings true:
“When you need money badly, you get money badly.”
When financial firms smell blood, they extract their pound of flesh! If you need cash desperately, you receive cash on bad terms – lenders add high interest rates and restrictive covenants that limit business decisions.
Therefore, one wants their business to be amply liquid.
Moreover, your dash for cash may be driven by a poor economic environment or a recession. If you are asking desperately for cash in a crisis maybe lots of other people are asking too. If everyone wants cash quickly banks get spooked and stop lending, reducing liquidity in the economy – a classic “liquidity crunch”. This is a sign of severe financial distress in the economy.
See the graph below. Commercial paper is very short term debt due in less that 270 days. Commercial paper is used by companies to pay short term liabilities while they wait for operations to generate cash and their Inventory, Accounts Receivables to convert to cash.
During the Global Financial Crisis the commercial paper market, which provides liquidity to large institutions, completely evaporated. Those that needed liquidity were unable to get it! A big casualty of that was a historic bank called Lehman Brothers. While they did take on a lot of leverage, what killed them was the inability to pay their short-term commercial paper.
Short-term debt can be helpful, but also very dangerous. Just before the Global Financial Crisis we saw there was $2.2 Trillion of very short-term debt. We can now see why this is a bad idea if you don’t have enough Current Assets to pay down your short-term liabilities. The market agrees as the current level is only $1.2 Trillion.
Ratios (Scroll down for West Pharma example)
The Current Ratio
The Current Ratio looks at a business’s liquidity. By comparing Current Assets to Current Liabilities the ratio assesses what needs to be paid in the next 12 months versus assets that convert to cash in 12 months at a point in time.
A mismatch of short-term assets may limit a company’s ability to produce required cash. Current Ratios of below 1x may indicate that a business could face liquidity troubles if Current liabilities come due faster than anticipated, and near-term revenue doesn’t produce produce enough cash to make up the difference.
On the other hand, a ratio of 3x or greater would suggest the company is stable with short-term funding. A high Current Ratio may suggest the company has too much cash. Keeping enough cash is great in case a disaster strikes. But after we have enough in our “disaster fund“ we should think about putting the money to work!
In December 2023, West Pharmaceuticals’ current assets are ~2.9x greater than their current liabilities showing their liquid position (calculation below). The company, however, may be holding too much cash – this is for an industry expert to decide.
The Quick Ratio
A second liquidity ratio we can use is the Quick Ratio. The ratio is nearly the same as the Current Ratio but we exclude Inventory and Pre-Paid Expenses from Current Assets. We do this because Inventory take longer to “convert to cash” than Accounts Receivable and thus often aren’t available in the very short term – think next 30 days. Pre-Paid Expenses are expenses paid upfront but don’t produce cash. Rather they “convert into a non-cash expense” as we consume the benefit. Therefore, we ignore inventory and pre-paid expenses and see how liquid is the company.
West Pharmaceuticals is still very liquid. The company can cover its current liabilities 2.24x with only Cash and Accounts Receivable.
The Cash Ratio
The Cash Ratio goes even further. Assuming only have cash; can you service your existing liabilities? West Pharmaceuticals can, in fact, 1.27x more. As you can see this is a highly secure balance sheet regarding short-term capital needs.
It is not common to have such good liquidity ratios, especially as an SMB. However, West Pharmaceuticals is a good case study for financial stability – a fortress balance sheet.
Nuances
The Liquidity Ratios, however, are not perfect. All Current Assets and all Current Liabilities are not equal. Current Assets alone don’t tell us when they convert to cash. The cash conversion of Inventory will generally take longer than Accounts Receivable. Moreover, Pre-Paid Expenses are expenses paid upfront but won’t convert to cash like Accounts Receivable or Inventory.
In addition, the Accounts Receivable, or Inventory balance may not be as accurate as we think.
Charlie often leaves flour at the bottom of his pantry to go stale. As a result, Charlie can’t sell (liquidate) his inventory. It is worth zero dollars and should be excluded. Another problem Charlie ran into was allowing a bankrupt company to buy his biscuits on credit. The company promised to pay Charlie $1,000 around five years ago yet Charlie still holds this on his balance sheet… Well as you can probably tell this is unlikely to be repaid anytime soon, if at all so Charlie should write this value down to zero.
We need to apply common sense when using ratios. Think about what makes up each category. Is it right to include all the amounts in our calculation? Including faulty numbers will distort the reality of the underlying business.
Dales Sales Outstanding
DSO measures the amount of time it takes to receive payment from Accounts Receivable, on average.
We take the average accounts receivable balance from this year, and the previous year which is divided by revenue of the year then multiply the result by 365.
When managing at a business’ cashflow it is important to have an idea to see how long it takes Accounts Receivables to convert to cash. As explained before, the Accounts Receivable on a balance sheet is helpful but doesn’t tell us when they will convert to cash. When looking at our current liabilities, DSO will give us a better idea of the liquidity profile of our Accounts Receivables.
Based on last year’s results, DSO gives us an approximation of how long it takes AR to convert to cash.
A DSO of 120 tells us it takes a just under four months to convert AR to cash – a long time to collect cash. Average DSO for large companies in the US is ~60 days so we can think that the average for SMBs is 70-80.
The industry and business model will cause DSO to vary. If you want to compare your DSO to industry averages make sure you are comparing a similar business model.
We are going to come back to DSO in a later post on Working Capital so I will leave this hear for now.
Days Inventory Outstanding
DIO tells a similar story for Inventory. DIO tells us, on average, how many days it take to sell Inventory, or how long our cash is tied up in Inventory. The lower the DIO the less time it takes to liquidate (sell) inventory, and vice versa.
Similar to above, when managing at a business’ cashflow it is important to have an idea to see how long it takes Inventory to convert to cash. The amount of inventory on a balance sheet doesn’t tell us when our products will be sold, and we can expect cash to arrive in our bank accounts.
DIO will give us a better idea of the liquidity profile of our Inventory.
However, be careful. Depending on your business, when you sell your Inventory you may not get a cash payment! Customers may agree to pay on credit. The Inventory balance converts into Accounts Receivable!
Since we just learned how to estimate the length of time it takes to receive payment from Accounts Receivable this shouldn’t be a problem…
You guessed it! We add DIO and DSO. Adding the two calculations (DIO + DSO) will give us a rough estimate of time for it takes inventory to be sold and then convert the corresponding Accounts Receivable into cash!
A high DIO can be problematic. It may suggest there is either A) “obsolete” inventory that is unsellable pushing the balance up artificially high B) too much inventory is being held C) the company is struggling to sell its inventory or D) keeping enough inventory for expected increase in sales E) higher prices expected in the future so holding excess inventory to take advantage.
We can leave DIO there for now. We will go into more depth in the Working Capital post in our fundamentals series.
Final Thoughts
How do you feel? Hopefully, your understanding is more liquid… Sorry for the Dad joke 🙂
Liquidity is a core concept in running a business. Being able to pay our short-term obligations is integral to keeping your business out of bankruptcy. A good company can have a liquidity problem and go out of business because they are unable to find short-term cash. We must be able to assess, understand and correct our own liquidity positions to better capitalize our business.
That is not to say I am telling you what your ratios to be. You understand your business and your industry more than me. I am just providing a framework to look at your business.
See you at the next post 🙂