Managing and Measuring Liquidity | CFA Level I Corporate Issuers

In this lesson, we’ll dive into liquidity management and explore some methods to measure a firm’s liquidity. We’ll also learn to evaluate a company’s effectiveness based on its operating and cash conversion cycles.

Liquidity and Liquidity Management

Liquidity in the corporate context refers to a company’s ability to meet its short-term obligations, such as payments to vendors, staff salaries, rent, interest payments to creditors, and repayment of upcoming debt. Liquidity management involves a company’s processes to meet these liquidity needs, which is especially crucial for firms in tighter financial situations to ensure solvency.

Primary and Secondary Sources of Liquidity

Although the sources of liquidity vary among firms, they can generally be categorized as primary and secondary sources:

• Primary sources are used for a company’s normal day-to-day operations, such as cash balances from selling goods and services, collecting receivables, and generating cash from short-term investments. Short-term funding can also be obtained through trade credit from vendors and lines of credit from banks.
• Secondary sources include liquidating assets (both short-term and long-lived), renegotiating debt agreements with existing creditors, or even filing for bankruptcy or restructuring the company.

Companies should strive to avoid relying on secondary sources for liquidity, as they can significantly change the company’s financial structure and signal a deteriorating financial position to stakeholders.

Drags and Pulls on Liquidity

A company’s liquidity position can be affected by various factors, which can be described as drags and pulls on liquidity:

• Drags on liquidity delay or reduce cash receipts, such as uncollected receivables, obsolete inventory, and tight credit environments.
• Pulls on liquidity accelerate cash outflows, such as paying vendors sooner than optimal, lowered credit limits by suppliers, and reduced lines of credit from banks.

Companies should be aware of these factors and build sufficient buffers to handle such circumstances.

Liquidity Ratios and Turnover Ratios

We can measure a firm’s liquidity position using liquidity ratios and turnover ratios:

• Current Ratio = Current Assets / Current Liabilities
• Quick Ratio = (Current Assets – Inventory – Prepaid Expenses) / Current Liabilities
• Cash Ratio = (Cash + Marketable Securities) / Current Liabilities
• Inventory Turnover = Cost of Goods Sold / Average Inventory
• Receivable Turnover = Revenue / Average Receivables
• Payables Turnover = Purchases / Average Payables

By converting these ratios to days, we can analyze a firm’s operating cycle:

• Days of Inventory on Hand (DOH)
• Days of Sales Outstanding (DSO)
• Number of Days of Payables

The operating cycle begins when inventory is purchased (often on credit) and ends when cash payment is received from the customer. A business owner would typically prefer to delay paying suppliers and collect money from customers as quickly as possible, shortening the cash conversion cycle.

Cash Conversion Cycle = DOH + DSO – Number of Days Payable

A shorter cash conversion cycle implies that the company needs to finance its inventory and accounts receivable for a shorter period of time, while a longer cycle indicates lower liquidity and potentially a need for higher capital to fund current assets.

And that concludes our lesson on managing and measuring a firm’s liquidity. In the next lesson, we’ll explore the management of a firm’s cash position.