Liquidity / Liquidity metrics
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright © 2011 by Marty J.Schmidt. Revised 11 January 2012.
The Meaning of Liquidity Metrics (Liquidity Ratios)
Liquidity is regarded as the a company's ability to meet current (short term obligations). Liquidity is measured with several financial statement metrics (financial statement ratios), including
Working capital
Current ratio
Quick ratio (Acid test ratio)
Accounts payable turnover (APT)
Cash conversion cycle (CCC).
All these metrics address the question: How well positioned is the company to pay its immediate bills? Among the metrics mentioned, the acid-test is the most severe (most pessimistic).
The financial analyst may regard poor scores on liquidity metrics (liquidity ratios) as a signal that the company is unable to invest in research and development that it needs in order to remain competitive. Or, poor liquidity financials can mean that the company will have to cut corners on infrastructure maintenance, or reduce advertising and promotion expenses (thereby cutting into future sales). In extreme cases, the company may not even be able to meet payroll.
Employees may feel the effects of liquidity problems through such measures as pay rate freezes and restrictions on hiring, travel, and training. Good liquidity, on the other hand, means that management has the ability to pursue objectives other than "survival" objectives, which contribute instead to the stability and growth of the company.
• Five Liquidity Metrics (ratios)
– Working Capital
– Current Ratio
– Quick Ratio / Acid Test Ratio
– Accounts Payable Turnover (APT)
– Cash Conversion Cycle (CCC)
• Sample Income Statement
• Sample Balance Sheet
[ Page Top] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
Five Liquidity Metrics
Five of the most commonly used liquidity metrics are current ratio, working capital, the quick ratio (acid-test ratio), accounts payable turnover (APT), and the cash conversion cycle (CCC). All take their input data from balance sheet and income statement entries (the full statements from which these entries are taken are presented in the sections below, Sample Income Statement and Sample Balance Sheet). These metrics are sometimes referred to as liquidity ratios (although not all are true ratios).
Note the focus on immediacy and the short term view in the input data for these metrics. The first two of these metrics (working capital and current ratio) use "inventories," a balance sheet category contained within "Current assets." The idea is that current assets could be turned into cash relatively quickly. By this reasoning, inventories are current assets (whether raw materials inventory, work in progress inventory, or finished goods inventory), because any of the three kinds of inventories could be turned into finished goods and then into cash in a short time. However, compared to other current assets (such as cash or accounts receivable, inventories are the least liquid). For this reason, the most severe (conservative) liquidity metric here, the quick ratio (acid test ratio), removes the value of inventories from other current assets in the calculation.
Similarly, Current liabilities brings a near-term focus to several of these metrics because this category includes only the bills the company must pay in the short term, usually defined as one year.
Data for the example calculations shown here are taken from the sample financial statements below:
From the sample balance sheet:
Current Assets: $9,609,000
Current Liabilities: $3,464,000
Inventories: $5,986,000
Accounts Payable: $1,642,000
Accounts Receivable: $1,832,000
From the sample income statement
Net sales revenues: $32,983,000
Cost of goods Sold: $22,043,000
Working Capital
Working capital is a figure in currency units (e.g., $, €, £ or ¥) showing the difference between current assets and current liabilities:
How is working capital calculated?
Working capital = Current assets – Current liabilities
= $9,609 – $5986 = $3,623
How much working capital is sufficient? Company management will attempt to address that question by projecting their current liabilities for the next year and the expected cash inflows for the next year.
Current Ratio
The current ratio metric is built from the same input data as the working capital metric, except that here a ratio is produced by dividing current liabilities into current assets:
How is current ratio calculated?
Current ratio = Current assets / Current liabilities
= $9,609 / $5986 = 1.61
This company's current ratio may be cause for concern among analysts, because a current ratio value of 2.0 is a generally used "rule of thumb" requirement for healthy liquidity. (While a current ratio under 1.0 might be considered cause for alarm).
Quick Ratio / Acid-Test Ratio
The most severe liquidity test of the three presented here is the quick ratio, or acid-test ratio. This ratio is similar to the current ratio, except that the inventories figure is subtracted from current assets before performing division. The idea is that inventories are the least liquid of the current assets components:
How is quick ratio calculated?
Quick ratio = (Current assets – Inventories ) / (Current liabilities)
= ($9,609 – $3,464) / $5986 = 1.03
Here, too, this company's acid-test ratio might be cause for concern. Analysts generally consider an acid-test ratio of about 1.1 as a minimum healthy level.
Accounts Payable Turnover (APT)
Accounts payable turnover (APT) is meant to measure the number of times that a company pays off its suppliers during the accounting period.
The APT liquidity metric carries the same information as an activity/efficiency metric, days payable outstanding (DPO). Both metrics are based on the same input data (Cost of goods sold (or "supplier purchases") and total accounts payable (or average accounts payable). APT is a frequency, that is, number of "payoffs" per period. DPO is a measure of time, the average number of days per payoff.
How is accounts payable turnover calculated?
Using the example data listed above, accounts payable turnover may be calculated as follows:
APT = Cost of goods sold / Accounts payable
= $22,043,000 / $1,642,000
= 13.4 payoffs/year
The result here, 13.4 payoffs per year, indicates the company pays off creditors about monthly, or slightly faster. That is to be expected where most creditors ask for payment "net 30", asking for payment no more than 30 days after receipt of invoice. A higher APT frequency might indicate that the company is having trouble obtaining credit, or is simply not making best use of funds (e.g., not holding putting funds to work earning interest for a while before payoff). On the other hand, a trend towards a much lower frequency, e.g., 5-6 payoffs per year, indicates either that the company's creditors are granting long credit terms (e.g., "net 60 days" or "net 90 days), or that the company is overdue on paying many of its bills.
The activity/efficiency metric, days payable outstanding (DPO) can be calculated by dividing the number of days per period by the APT. For a 365 day year period
DPO = Number of days / APT
= 365 / 13.4
= 27.2 days
When the focus is on efficient use of resources, the DPO activity/efficiency metric version of this information is viewed as more helpful. When the focus is on the company's liquidity, the APT frequency version is viewed as more helpful, even though both metrics carry exactly the same information.
Note that some analysts prefer to calculate APT and DPO using "supplier costs" in place of "cost of goods sold" (or "cost of sales" or "cost of service"). This is especially appropriate when large components of "cost of goods sold" represent expenses other than purchases on credit from suppliers (e.g., when large components of cost of goods sold include direct labor and indirect labor costs for the company's own employees).
Cash Conversion Cycle (CCC)
The cash conversion cycle metric (CCC) addresses the question: How long does it take the company to turn its own cash investments (cash paid to suppliers) into incoming cash from customers?
Clearly, CCC qualifies as a liquidity metric, but CCC is also considered a measure of management effectiveness or efficiency. The cash conversion cycle, in fact is computed from three efficiency metrics: (1) days inventory outstanding, DIO, (2) days sales outstanding, DSO, and (3) days payable outstanding, DPO (see the encyclopedia summary of activity and efficiency metrics for more on these components of CCC).
How is cash conversion cycle calculated?
The cash conversion cycle is a measure of time, expressed in days, whose three components are also time measures expressed in days:
CCC = DIO + DSO - DPO
Suppose, for instance, for this company example,
Days inventory outstanding (DIO) = 98.7 days
Days sales outstanding (DSO = 20.3 days
Days payable outstanding (DPO) = 27.2 days
The calculation of these input metrics is shown below, but consider first the resulting cash conversion cycle:
CCC, = 98.7 + 20.3 – 27.2
= 91.8 days
Note that days payable outstanding is subtracted from the DIO+DSO total, assuming that the company did not issue cash payment immediately for inventory purchased, but rather waited its customer DPO period before paying.
The CCC figure has meaning primarily when compared to other CCC figures:
- CCC tracked over time for the same company: Trends towards a shorter CCC indicate improved management efficiency and improved liquidity. Trends towards a longer CCC indicate the opposite. When the CCC is lengthening, management will look especially at the CCC components and try to identify the primary source of the change and target that for action.
- CCC for one company compared to CCC for its competitors: When a company's competitors in the same industry have a superior CCC (shorter CCC), management will try to determine whether the difference is due to differences in business models, differences in competitive strategies, or simply to different efficiencies in manufacturing, sales, or marketing.
For this CCC example, the three component measures were calculated from the sample data listed above as follows:
(1) Days Inventory outstanding (DIO)
= Days per year / Inventory turns per year
= 365 / 3.7
= 98.7 days
Where
Inventory turns per year
= Cost of goods sold / Total inventories
= $22,043,000 / $5,986,000
= 3.7 turns / year
(2) Days sales outstanding (DSO)
= Net sales revenues for the year / Days per year
= $32,983,000 / 365
= $90,364 sales revenues per day
(3) Days Payable outstanding (DPO)
= Net accounts receivable / Net sales revenues per day
= $1,832,000 / $90,364
= 20.3 days
[ Page Top] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
Sample Income Statement
Some of the data for the accounts payable turnover CCC metrics were taken from this sample income statement.
Grande Corporation Gross sales revenues.................33,329 Gross profit.................................10,940 Operating expenses Operating income before taxes............... 3,130 Financial revenue & expenses Income before tax & extraordinary items..... 2,737 Extraordinary items Net Income (Profit).......................... 2,126 |
[ Page Top] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
Sample Balance Sheet
Data for the liquidity metrics calculations above were also taken from this sample balance sheet:
Grande Corporation Assets Liabilities Owners Equity |
For a complete introduction to financial metrics, including a working set of interrelated financial statements and over 100 financial metrics derived from them, see Financial Metrics Pro.
[ Page Top] [ Encyclopedia ] [ Business Case Books & Tools ] [ Home ]
© Copyright Solution Matrix Ltd and 
Marty J. Schmidt+ 2004 - 2012. Legal notice. Unauthorized use or publication strictly prohibited under United States and International Copyright Law. Request permission to use.
Solution Matrix Ltd
Solution Matrix Germany
Solution Matrix Asia
Solution Matrix Pacific