Liquidity for any organisation is one the measure for its financial condition such as:
i. whether it will be a going concern in future,
ii. how it will pay off its cash obligations in short term
A. Generally, liquidity measure considered is the Current ratio or Quick Asset ratio/Acid test ratio. The emphasis of these ratios are on how quickly the assets can converted to cash in normal operating cycle. However, Cash conversion cycle approach addresses some its deficiencies:
i. it measures liquidity at one point in time
ii. it does not consider time taken in converting assets into cash and also time in paying the creditors
iii. it can be easily manipulated to show better liquidity position.
Example1: A company having 20 lakh current asset and 15lakh current liability will have current ratio as 1.333 times. Now, if the company wishes to show higher liquidity ratio, it will pay off some of its creditors say 5 lakh, disregarding its other implications like- it was not required to make payment at that time, could have used funds interest free or could have invested elsewhere or earned interest till the due date of payment. The result is a better current ratio of 2 times.
Example2: A good current ratio may be due to higher accounts receivables pile up which is not a sign of good liquidity position as it shows lack of company’s ability to collect receivables in time and also the increased cost of financing such receivables in terms of interest cost if taken loan/overdrafts and the opportunity cost of such funds.
B. Cash conversion cycle formula = Days Inventory Outstanding + Days Receivable Outstanding - Days Payable Outstanding
1. Days Inventory Outstanding = Average inventory / (cost of goods sold ÷ 365) - It is the measure of number of days company takes to convert its inventory into sales.
2. Days Receivable Outstanding = Average Accounts Receivable/ (Net Credit Sales ÷ 365) – it measures the duration of collection period from debtors.
3. Days Payable Outstanding = Average Accounts Payable / (Cost of goods sold ÷ 365) – it is the time company takes to make payment to its creditors.
This method advocates to cover the limitations of the traditional liquidity measure through Current ratio or Acid Test ratio as it considers time and is not static. Shorter the conversion period better would be the working capital position and the liquidity. Interestingly, the components of the formula is the combination of three elements of working capital cycle. That are:
1) Inventory Turnover Ratio is measure of how quickly inventory is converted to sales, in number of times
Mathematically, Ratio = Cost of Goods sold/ Average Inventory. The more the ratio better it is.
2) Debtor Turnover Ratio measures the number of times credit sales is converted into money i.e the collection from debtors. Ratio = Net Credit Sales/ Average Debtors. The more the ratio better it is
3) Creditors Turnover Ratio is the measure of time taken to make payment to creditors, i.e number of times
Ratio = Cost of Goods Sold/ Average Creditors. The less the ratio better it is.
C. Some other ratios useful in liquidity analysis can be:
i. Cash Ratio or Absolute Liquidity Ratio – it measures the ratio of liquid assets available to meet current liabilities, Ratio = Cash + Marketable Securities/ Current Liabilities
ii. Basic Defence Interval – time to cover up the cash expenses without additional financing in the event of business operational failure.
Ratio = Cash + Receivables + Marketable Securities / (Operating Exp. + Interest + Income Taxes) ÷365
Each one of the above approach has its pros and cons and not any single method can give true picture, instead, they complement each other. So, when these tools used in combination, it will give a thorough and broader range of analysing liquidity position of a company.