Liquidity of Current Liabilities

The term “liquidity of current liabilities” refers to the quality of current liabilities. The quality of current liabilities includes the following considerations:

• How urgent is the payment of the current liabilities? Tax liabilities must be paid when due, no matter what else has to be paid, and thus they have top priority. Payroll liabilities also have a priority claim on cash inflows. Any time tax liabilities or payroll liabilities are higher than normal, they must be questioned, because the increase could indicate the company is not paying those obligations in a timely manner. Liabilities to suppliers with whom the company has a long-standing relationship may have more latitude and can sometimes be delayed for a short period if necessary.
  However, too much delay in paying suppliers’ invoices will result in the company’s losing its credit privileges because suppliers will require the company to pay for everything in advance.
• Does the company have any unrecorded liabilities that have a claim on current funds ? Examples of unrecorded liabilities are purchase commitments or short-term leases that are expensed.
• Is the company in violation of any of its loan covenants ? A violation of loan covenants constitutes a default and as such, renders a long-term debt due and payable immediately.
• Are the company’s loan payment obligations current ? Failure to remain current with loan payment obligations is also a default that renders debt immediately due and payable.

Thus, the analyst has a responsibility to look beyond the numbers on the balance sheet and determine whether those numbers need to be adjusted to reflect the firm’s actual condition, because the firm’s actual condition may be quite different from what is implied by a simple ratio that is indiscriminately calculated

A  covenant  ⇒ is a condition or a requirement in a loan agreement or a bond indenture. A bond indenture is the legal contract that specifies the bond’s features such as the maturity date, the interest rate, the timing of interest payments, and all the applicable terms and conditions. Covenants may restrict the actions of the borrower or require that they meet certain ratio requirements. If the borrower fails to meet the requirements of the loan agreement, the loan becomes in default, just as if the borrower had failed to make scheduled loan payments.