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Survival 101: Keeping The Liquidity Tap Flowing
Education | 21 October 2011
By: jason.liew
Articles (66) Profile

Three years after the Lehman Brothers bankruptcy, we are back to square one. That is, a face-off with liquidity issues. Only now, in place of bad household debts, sovereign debts in Europe have accumulated to a level that is proving unsustainable. With all the hoo-ha surrounding the region’s debt crisis, the importance of liquidity in one’s financial system cannot be further emphasised.

Companies, and nations alike, face liquidity risks. There are basically two kinds of liquidity risks – asset and funding. Asset liquidity risk relates to the ease with which an asset can be converted, without affecting its market price much, into a liquid medium, preferably cash. The other, funding liquidity risk, has to do with one’s ability to settle obligations when due.

This brings us to the gist of the article – how exactly do you go about assessing whether a firm is holding enough liquid assets to ensure smooth transactions in servicing its debt commitments, while at the same time not impede its day-to-day operations?

Liquidity Ratios
As the name suggests, liquidity ratios express a company’s ability to meet short-term creditors’ demands. Before we get involved with the math stuff, let us first establish that all the figures that are used in the following calculations can be found in a company’s balance sheet statement. Also, the terms short-term and current refers to a period of a year or less.

There are three widely-used measures of liquidity: current ratio, quick ratio and cash ratio.

As you can see, a major distinction between these ratios is the types of current assets used in the calculation. The segregation of current assets reflects that not all components of current assets, such as inventory, are easily converted at full value on short notice. That said, while providing a true test of liquidity is imperative, going with the most conservative measure may not be realistic as such a company would have to intentionally maintain cash assets at a level high enough to cover its current liabilities.

Deciphering The Figures
Taking the example of Jardine Matheson Holdings (refer to Table 1), for every US$1 the company owes in the short-term, it has US$1.28 available in its current assets that can be used to cover this short-term debt obligation.

One may ask: Is that acceptable? There is no number that applies across-the-board. Depending on which industry a company is in, different companies would have varying ratios. Thus, to make a meaningful comparison, companies within the same industry would have to be picked. Nonetheless, as a general rule, companies with higher coverage of liquid assets to short-term liabilities are better-off than those with lower coverage.

Factors such as inventory turnover, account receivable and payable turnovers do come into play as well. A company, with a high current ratio, may actually take considerably longer time to collect its receipts compared to the interval period it has to make payment to its creditors. This may, in turn, lead to a misleading conclusion.

Furthermore, a high ratio may also signal that a company is not utilising its assets to the best advantage to bring maximum value to its shareholders.

Scanning through the current and quick ratios would reveal that most companies exhibit relatively close current and quick ratio figures as well. There are, however, a few with current ratio figures being significantly higher of the two. For situations like these, it would indicate that the company’s total current assets are highly dependent on inventory.

A Company’s True Liquidity
When using these ratios to evaluate a company’s liquidity, investors have to bear in mind that these measures are based on the concept that all of the firm’s current assets will be liquidated to service all of its current liabilities. This is a highly unlikely event given a business is a going concern. Therefore, what is actually important is the “quickness” of a company’s cash conversion process.

To sum it up, liquidity ratios do give information about a firm’s ability to meet its short-term financial obligations. Still, they should not be used in isolation. Complementing its use with other financial ratios such as asset turnover ratios and other liquidity metric like cash conversion cycle, would certainly provide investors with a clearer picture.

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The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

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