8
Short-term liquidity
This chapter reviews short-term liquidity measures:
- Current and quick ratio
- Working capital to sales
- Working capital days
Short-term liquidity measures
The first test of a company’s financial position is, ‘Will it have sufficient cash over the immediate future to meet its short-term liabilities as they fall due?’ Unless the answer here is positive, the company is in a financial crisis irrespective of its profit performance.
Normally short-term liabilities amount to a considerable part of the total borrowings of the company. They are always greater than the company’s physical cash resources. The question we ask is, ‘Where will the cash come from to pay them?’
Cash is in constant movement through the company. It flows in frequently from accounts receivable as customers pay their bills. Each payment reduces the total accounts receivable balance outstanding, unless it is in turn topped up by transfers from the finished goods inventory as new sales are made. The finished goods inventory is likewise fed from raw materials and work in process. We can visualise these assets as temporary stores for cash, i.e. inventories in various forms and accounts receivable. These are the assets that collectively make up ‘current assets’. They amount to a high percentage of a company’s total investment.
At the same time, goods are being purchased on credit from suppliers, thereby creating short-term liabilities. Normally other short-term loans are being used as well. It is these that we collectively refer to as ‘current liabilities’.
We measure a firm’s short-term liquidity position by comparing the values of ‘current assets’ with its ‘current liabilities’.
There are three key ways of evaluating this relationship:
- the current and quick ratios
- ‘working capital to sales’ ratio
- working capital days.
Current ratio
The current ratio is a favourite of the institutions that lend money. The calculation is based on a simple comparison between the totals of ‘current assets’ and ‘current liabilities’.
Current assets represent the amount of liquid, i.e. cash and near-cash, assets available to a business. Current liabilities give an indication of its upcoming cash requirements. Institutions expect to see a positive cash surplus. We therefore look for a value comfortably in excess of 1.0 for this ratio. While this is the standard for most types of businesses, certain types of operation are capable of operating at a much lower value.
In Figure 8.1 we can see that the current ratio for the Example Co. plc is 1.3 times.
A word of caution is needed concerning the interpretation of this or any other ratio for a particular company. A wide diversity of conditions exist in different types of business. Some businesses are able to exist comfortably with liquidity ratios that would spell disaster for others. Some companies have to carry large stocks, have long production cycles and offer long credit to customers. Other businesses carry almost no stock and receive more credit from suppliers than they give to customers.
One ratio value in isolation tells us little. To get a good picture of a situation we must use a series of tests and we must apply appropriate benchmarks. These benchmarks can be derived from many sources, such as historical data, competitors’ accounts and published data of all kinds.
It can be said, regarding liquidity ratios, that it is the trend over time rather than the absolute value that gives the most valuable information. A current ratio of 1.3 could give either a good or bad signal depending on past results.
A disadvantage of this ratio is that it does not distinguish between different types of current assets, some of which are far more liquid than others. A company could be getting into cash problems and still have a strong current ratio. This issue is somewhat addressed by the next ratio.
Quick ratio
The calculation here is very similar to that of the ‘current ratio’. Simply remove the ‘inventories’ value from the ‘current assets’ and divide the result by the ‘current liabilities’ total.
The reason for excluding the inventory figure is that its liquidity can be a problem. You will recall that the term ‘liquidity’ is used to express how quickly, and to what percentage of its book value, an asset can be converted into cash if the need were to arise.
For instance, a cargo of crude oil in port at Rotterdam has a high liquidity value, whereas rolls of material for making fashion garments stored in a warehouse probably have a low liquidity value.
We can meet with a situation where a company has a constant current but a falling quick ratio. This would be a most dangerous sign. It tells us that inventory is building up at the expense of receivables and cash.
Lending institutions have difficulty in ascertaining the liquidity of many types of inventory. They feel much more comfortable when dealing with receivables and cash. Accordingly they pay quite a lot of attention to the ‘quick ratio’.
Both the current and quick ratios are the most widely used measures of short-term liquidity but a problem with them is that they are static. They reflect values at a point in time only, i.e. at the balance sheet date. It is possible to ‘window dress’ a company’s accounts so that it looks good on this one day only. To deal with this shortcoming it is argued that cash flow over the short-term future would be a better indicator of ability to pay. The ‘working capital to sales’ ratio covered next meets this objection to a certain extent.
In Figure 8.2 we can see that the quick ratio for the Example Co. plc is 0.8 times.
A value of 1.0 is usually very strong. It means that the company can pay off all its short-term liabilities from its cash balances plus its accounts receivable. Most companies decide that such a level of liquidity is unnecessary. An alternative name for this ratio is the ‘acid test’ ratio.
Working capital to sales ratio
The working capital to sales ratio gives us a glimpse of the liquidity position from yet another angle. This measure shows up some features that cannot be ascertained easily from the previous two measures.
Working capital is ‘current assets’ less ‘current liabilities’.
The working capital to sales ratio looks at working capital as a percentage of ‘sales’.
In Figure 8.3 we can see that the working capital to sales ratio for the Example Co. plc is 7%.
Whereas the current and quick ratios use balance sheet figures only, here we take into account the ongoing operations by including a value from the profit and loss account. The ‘sales’ figure reflects, to some extent, the operating cash flow through the whole system. This ratio, therefore, relates the short-term surplus liquidity to the annual operating cash flow.
The working capital to sales ratio indicates the amount of cents in every dollar that is required to fund working capital. For the Example Co. plc, illustrated in Figure 8.2, this would be 7 cents in every dollar, which is very low.
Cash flows from managing working capital, essentially the cash received from customers after paying off its bills and short-term debts, is an essential source of short-term operational finance for a business. As sales grow, working capital or the cash required to finance operational expenses should usually grow in the same proportion. Therefore changes in the working capital to sales ratio should be investigated further.
This will often highlight a trend the other ratios miss. It is possible to have a stable ‘current’ or ‘quick’ ratio while this ratio is falling. This would happen if sales were increasing rapidly but levels of working capital were static. A condition known as ‘overtrading’ could develop.
The term ‘overtrading’ is used to describe a situation where there are not sufficient liquid resources in the balance sheet to meet comfortably the day-to-day cash needs of the existing level of business. It arises in a company that has grown too fast or has been underfunded in the first place. The symptoms show up as a constant shortage of cash to meet day-to-day needs. There is a danger of bankruptcy. Probably the only solution to the condition is an injection of long-term liquid funds.
There is a difference between being short of ‘working capital’ and managing the business so that less ‘working capital’ is needed. The latter is a sign of good management. The modern trend is towards a lower ‘working capital to sales’ ratio, particularly in the form of much reduced inventories. A low, but not too low, working capital to sales ratio can be an indication of efficiency.
Please note that some businesses use the reciprocal of this ratio, i.e. sales to working capital.
Working capital days
Possibly the clearest way of looking at the role of working capital in a company’s operations is through working capital days.
We saw this concept in passing in Chapter 6 when we looked at model variations for performance drivers.
We have used the term ‘working capital’ here to include three items only, i.e. ‘inventory’, ‘accounts receivable’ and ‘accounts payable’, whereas the classic definition of working capital covers all items in ‘current assets’ and ‘current liabilities’. We only look at these three items because they are:
- the dominant accounts within working capital; and
- their behaviour is spontaneous – they react very quickly to changes in levels of company turnover.
The company will have policies regarding levels of inventory, accounts receivable and accounts payable. However, these policies will not fix the absolute values of these balances, which will be changed according to the level of sales. A sustained growth in sales, for example, will inevitably result in the growth of these three balances.
The main items excluded are ‘cash’ and ‘short loans’ which depend on policy decisions. For operating management purpose, this narrow definition is more useful.
We have used data from accounts of the Example Co. plc for ‘inventory’, ‘accounts receivable’ and ‘accounts payable’. Each category is divided by sales and then multiplied by 365 days. This calculates the number of days of each category – for example, how many days the business holds inventory, how many days it takes to collect receipts from customers and how many days it takes to pay its suppliers.
The calculations are shown below:
Inventory days
Accounts receivable days
Accounts payable days
We have plotted this data in Figure 8.4, which is an interesting representation of the operating cash cycle time gap. The objective is to show the number of days that elapse from the time money is paid out to the suppliers of materials until the corresponding cash is received back from the customer that buys the goods.
We nominate day 0 to indicate when goods are received from suppliers. Given the average stockholding period, day 42 indicates when the goods are sold. The customer takes on average 52 days to pay, so cash is received on day 94.
In the meantime the company, given its average number of days credit, will have paid the supplier on day 46. The time gap between the cash out on day 46 and its return to the company on day 94 is 48 days. (In addition the company will have paid out in respect of wages, salaries and overheads all through the period.)
It is this time gap that creates in a company the need for working capital. The amount is easily quantified. Given a gap of 48 days, each $1m of sales requires ‘about’ $131,500 ($1m × 48/365) of working capital. Every increase of $1m will create a need for an additional $131,500 in cash resources. This point is often missed by small rapidly growing companies who find themselves in cash difficulties in the midst of high sales and profits. This is typical of ‘overtrading’ companies.
The working capital days ratios are often categorised as ‘efficiency’ ratios as they are useful indicators of how efficient management are in running a business.