Young Investor

The right measure of liquidity

P. Saravanan N. Sivasankaran | Updated on August 13, 2011

Investors can look at alternative methods to measure liquidity.

Measuring the liquidity position of a company can help you maximise your profits.

Every time there is global turmoil, everyone talks of a ‘liquidity crunch' or liquidity crisis. But what does liquidity mean for a company and how do you measure it?

Accountants in fact size up companies on three main parameters- “Profitability”, “Liquidity” and “Solvency” measures. The next question which is raised here is “which one is more important?” - Should an organisation channelise its resources towards the objective of maximising profits or liquidity or solvency?

The obvious answer from the experts is going for a trade-off between liquidity and profitability. This means the company should strike an optimal balance between the two measures of liquidity and profitability. That said, the two however are inter-related. That is to say, no organisation can achieve superior profitability numbers without having a superior liquidity position. Similarly, sound liquidity is an off-shoot of sound profitability. So, it is a cycle where one contributes to the other.

Let us discuss the ways in which one can measure the liquidity position of a company.

Understanding liquidity

Liquidity refers to the ability of a company to meet its immediate obligations without any trouble or strain. The obligations for a business may consist of items such as accounts payable for the suppliers of raw materials, taxes payable, utilities payable and other accrued expenses. How does a company pay all these obligations? It is through cash.

Where from an organisation gets the required cash for meeting all these obligations? It gets cash from the existing cash balance in hand, bank account balances and realisation of cash by converting the current assets such as account receivable, note receivable and inventories into cash.

Its importance

The above explanation shows that liquidity contributes to profitability. So what will happen to the organisation whose performance suffers from a poor liquidity position? This means that this organisation is finding it hard to meet its payment obligations to outsiders such as suppliers/vendors of material.

If this situation continues, the vendors will not supply the required materials for the production activities and may even blacklist the company. Poor liquidity position thus can bring upon many challenges, which could even result in liquidation if not addressed properly.

Traditional Measures

Business entities have so far have relied on two major measures to gauge their liquidity position. One is current ratio and the other one is liquidity or quick ratio (popularly known as the acid-test ratio).

The current ratio is computed by dividing the total of current assets by the total of current liabilities. Here current assets are defined as assets that are convertible into cash in one year or one operating cycle, whichever is higher. Examples include cash in hand; cash at bank, short-term marketable securities, accounts receivable, notes receivable, inventories and pre-paid expenses. Current liabilities are those obligations that are to be settled in one year or one operating cycle, whichever is longer.

A current ratio of 2:1 is considered to be good /satisfactory in theory. This indicates that the company has twice the amount of money invested in current assets than that of the amount required for meeting its current liabilities. However, practicality suggests that the judgment on whether a company's liquidity position is good or bad should be based on the industry standard or benchmark.

Here, quick ratio is a better measure of the actual liquidity position of a company compared to the current ratio. The major flaw in using current ratio is that it uses inventories and pre-paid expenses in its definition of liquid assets while they are the least liquid assets in reality. Quick ratio removes this error by dividing the liquid assets by the current liabilities of a firm. Here, quick or liquid assets include all the current assets except inventories and pre-paid expenses. A quick ratio of one is considered satisfactory in theory. Again, investors need to look at the industry standard for the right interpretation about a company's liquidity position.

An alternative method

However, investors must not take a call on the liquidity position of a company just by going through the traditional liquidity measures alone. They need to look at the liquidity position of a firm based on the alternative method too.

You can do this by dividing the excess of long-term financing over the net fixed assets by the net working capital requirement of a firm. Here long-term financing is computed by adding the owners' equity with the non-current liabilities. Net fixed assets can be arrived at by deducting accumulated depreciation from the gross fixed assets, and net working capital by subtracting the total of current liabilities from the total of current assets excluding cash balance. This method suggests the following:

* Long-term funds available should be greater than the amount locked up in net fixed assets

* The amount of current assets [excluding cash] should exceed the amount of current liabilities of the organisation.

Some analysts also compute absolute cash ratio where liquidity is measured by dividing the sum of cash and near- cash assets by the sum of current liabilities.

Your analysis however shouldn't stop with this. If the company under consideration has a poor liquidity position, find out why it is so. How to go about it? Well, that's another long story.

(The authors teach Accounting & Finance at IIM, Shillong)

Published on August 13, 2011

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