Short Term Liquidity Analysis
Liquidity
is the ability of an asset to be converted into cash without significant price concessions. Liquidity is a relative measure of the proximity to cash of the assets and liabilities of the company and an indication of the company’s ability to meet its short term obligations.
Understanding the company’s ability to meet its obligations even if normal cash receipts are not forthcoming (imminent) would give management an indication of whether or not – and for how long – it could weather adverse consequences like a strike.
Liquidity ratios
measure the firm’s ability to satisfy its short-term obligations as they come due. Liquidity ratios include the current ratio, the quick ratio, and the cash ratio.
Lack of liquidity can limit a company’s financial flexibility, making it unable to take advantage of vendor’s discounts and other profitable opportunities. Liquidity problems can also lead to financial distress or bankruptcy.
Solvency
is the ability of a company to pay its creditors when the amounts become due, or the company’s debt paying ability in the long term.
Solvency ratios
measure the firm’s ability to satisfy its long-term obligations. Solvency ratios include the long term debt to equity ratio, the total debt to equity ratio, the debt ratio, and the financial leverage ratio.
Financial analysis focus on short- term, medium -term and long –term liquidity, when the time horizon is short , only few types of assets can be quickly converted to cash, as the time horizon increases more and more assets could be sold and converted to cash thus those assets are incorporated in medium -term and long –term liquidity measures.
notes :
1- current assets and Current liabilities are classified based on operating cycle or one year whichever is longer.
2- Current assets have lower liquidity risk and lower return when compared with investment in long-term assets, which have higher liquidity risk and higher- return.
3- Current assets usually includes; Cash and cash equivalents , Short-term investment usually in marketable (trading) securities, A/R, short term N/R, Inventories, Prepaid expenses and other current assets.
4- Current liabilities usually includes; A/P, short-term N/P, Accrued expenses, unearned revenues, dividend payable, Short term loans and current portion of long term loans.
Measures of short -term liquidity
Measures of short -term liquidity include the following :
1- Working capital (Net working capital) = Current asset – Current liabilities
2- Current ratio (called working capital ratio)
| Current Ratio = | Current assets |
| Current liabilities |
3- Quick Ratio (Called acid-test ratio)
| Quick Ratio = | Cash + Marketable Securities + Account Receivable |
| Current liabilities |
4- Cash Ratio (called supper quick ratio)
| Cash Ratio = | Cash + Marketable Securities |
| Current liabilities |
5- Cash to Current Assets Ratio
| Cash to Current Assets Ratio = | Cash + Marketable Securities |
| Current assets |
6- Cash flow Ratio
| Cash flow Ratio = | Cash Flow from operating activities |
| Current liabilities |
Cash flow from operation ratio measures liquidity over a period of time not as a point in time, thus this ratio overcomes the static nature of the current ratio.
The cash flow ratio reflects the significance of cash flow for settling obligations as they become due.
7- Net working capital Ratio
| Net working capital Ratio = | Net working capital |
| Total assets |
8- Sales to working capital Ratio
| Sales to working capital Ratio = | Net sales |
| Average net working capital |
A high sales to working capital ratio may indicate either very high sales (good indicator) or a low supply of working capital (potentially bad indicator). For example, a high ratio could indicate that a firm is undercapitalized and does not have the resources to invest in working capital.
Sales to working capital ratio is an aggregate liquidity measure.
Sales to working capital ratio is liquidity and also an activity measure because it measures the movement in current assets; it measures the firm’s use of working capital in relation to sales.
9- Accounts receivable turnover
| Accounts receivable turnover = | Net credit sales |
| Average gross receivables |
10- Inventory turnover
| Inventory turnover = | COGS |
| Average inventory |
Notes
- Short-term liquidity ratios measure the relationship of a firm’s liquid assets to current liabilities. Liquidity refers to the ease with which assets can be converted to cash. Thus, liquidity ratios provide information about the short-term viability of the business, i.e., the firm’s ability to pay its current obligations and to continue operations.
- Liquidity measures based on B/S balances, measures liquidity at a point in time, but it is not indicative of future cash flows (weakness point)