Importance of Liquidity

In my last three posting, Necessity of Working Capital, The Current Ratio Matters and Quick Ratio Analysis we looked at three ways to asses a company’s liquidity. While working capital, the current ratio, and the quick ratio are useful liquidity measures, they may need some refinement. Let’s dig a little deeper and try to understand more about the importance of liquidity and why just the basic calculation of any of these may not be as helpful as we may have first thought.

A Working Example

Assume you have the following information on some companies. This uses the same numbers in the earlier postings referred to above.

liquiditySome Analysis

In example one the working capital, current ratio, and quick ratio all indicate that this company should be able to meet current obligations. In example two we see a company whose ability to meet current obligations is still good but appears to be less certain and will require closer attention to managing assets and liabilities. Example three shows a company that likely is in some financial trouble. They lack sufficient resources to easily meet current obligations as they come due, could need additional capital, and may be in danger of having credit cut-off from suppliers and even going out of business.

Now for the Deeper Digging

If we really want to see clearly the importance of liquidity we need dig into the details some more. Assume the $850,000 in other current assets is all inventory. Now, let’s make some assumptions. Assume that inventory is only turning over four times a year, meaning it takes on average three months to convert the $850,000 of inventory to receivables. Now, let’s also assume that in the $650,000 of accounts receivable the breakdown is as follows in the chart below. It is well known that once receivables get over 90 days old the collectability is dramatically reduced, sometime as much as 50%. Let’s assume that 50% for this example. I have also made some assumptions as to the collectability of the rest of the accounts receivable. Below the receivables breakdown are the adjusted calculations for the current ratio, quick ratio, and working capital.

liquidity study
Note the dramatic impact on these calculations. This significantly changes the financial picture for all three companies and demonstrates the importance of liquidity. This is why the quality of current assets needs to be considered when making calculations for current ratio, quick ratio, and working capital. Also note that in the above example we only adjusted for possible uncollectible accounts receivable. We have not looked at the impact of slow turnover of inventory, but at four turns per year it is not very liquid and would undoubtedly make this even worse.

AimCFO would like to help you understand these and other important financial measures, as well as steps you can take to improve your financial strength.

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As always, your comments are welcomed.


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