Liquidity Analysis

Liquidity is the ability to convert assets into cash. Liquidity analysis is widely used by banks and other financial institutions to assess a business entity's ability to repay debt. Liquidity analysis measures can be categorized by current position analysis, accounts receivable analysis, inventory analysis, and accounts payable analysis.

Liquidity is commonly examined by evaluating ratios, including working capital, current ratio, quick ratio, accounts receivable turnover, average collection period, inventory turnover, days sales in inventory, accounts payable turnover, and days payable outstanding. Ratios are a way to analyze organizational performance using information found in the income statement, balance sheet, and statement of cash flows.

Current position analysis examines the current financial state of a business. It captures information that helps assess the short-term financial health of the company and its ability to manage cash flow. Formulas commonly used in current position analysis include working capital, current ratio, and quick ratio.

Used to gauge current financial position, working capital is a tool that measures a business entity's ability to pay current liabilities. Working capital is calculated by deducting current liabilities from current assets. It can be assessed monthly, quarterly, or annually. To illustrate, a company called Charlie's Camper Company has current assets of $525,000 and current liabilities of $210,000. The company’s working capital is $315,000. This means it has $315,000 of current funds left after considering all current liabilities. Another formula, the current ratio, measures the ability of a business entity to pay its current liabilities. It is computed by dividing current assets by current liabilities. Unlike working capital, the current ratio can be used to compare business entities' short-term liquidity because it compares current assets to current liabilities. A high current ratio indicates that the entity has the ability to cover its current liabilities, and a low current ratio indicates that the entity may struggle to cover its current liabilities. What is considered to be a high ratio varies by industry and is subjective. Going back to the example, Charlie's Camper Company has current assets of $525,000 and current liabilities of $210,000 to calculate a ratio of 2.5 or 250%. So, the company has $2.50 of current assets for each $1.00 of current liabilities. The quick ratio is a financial ratio measuring the ability to use highly liquid assets to pay current liabilities. The quick ratio is also commonly referred to as the acid-test ratio because it measures the organization’s ability to cover short-term cash flow demands without relying on selling inventory. Highly liquid assets include cash and other assets that can be converted into cash easily, such as temporary investments and accounts receivable. Less liquid assets, such as inventory, are excluded from the quick ratio. Though inventory and other similar, less liquid, assets do have value, they are more difficult to quickly turn into cash to help pay current liabilities. The quick ratio can be computed by dividing the highly liquid assets by the current liabilities. For instance, assume that Charlie's Camper Company has highly liquid assets of $310,000 and current liabilities of $210,000. In this example, Charlie's Camper Company has a quick ratio of 1.48 or 148%, which means that the company has $1.48 of liquid assets per each $1.00 of current liabilities. Much like the current ratio, the determination of a desirable quick ratio is subjective. Generally, a ratio over 1 indicates that the organization has sufficient short-term assets to cover its short-term liabilities.

Accounts receivable, for many organizations, are a significant asset in the current asset section of the balance sheet. Ability to manage credit terms and collections with customers is crucial to keeping accounts receivable accounts up to date and in keeping the organization’s cash flow healthy. Thus, measuring and assessing accounts receivable is important, and also reflects liquidity. Accounts receivable analysis ratios assess the ability of an entity to collect its accounts receivable. Accounts receivable turnover measures how often accounts receivable are converted into cash, on average, within a year. The accounts receivable turnover ratio can be computed by dividing sales (not cash sales) by the average accounts receivable.

To illustrate, assume Charlie's Camper Company has annual sales of $1,000,000 and average accounts receivable of $275,000. The accounts receivable turnover is 3.64, which means that, on average, accounts receivable is collected 3.64 times per year. The average collection period measures the number of days, on average, it takes a business to collect cash from sales on account. Both the accounts receivable turnover ratio and average collection period measure the efficiency of the collection process, just in different terms. The accounts receivable turnover shows how many times a year the total balance is collected, on average, and average collection period shows the same information, only in number of days. Number of days is a common way to measure performance, as it is a measure that is easy to understand and relate to. The average collection period is a predictor of future cash inflows. To illustrate, Charlie’s Camper Company’s average accounts receivable turnover is 3.64. So, 365 days per year divided by 3.64 calculates the average collection period at 100 days. This means it takes the company, on average, 100 days to collect its receivables.

Defined as the ability of a business entity to manage its inventory, inventory analysis uses two ratios to accomplish its goal: inventory turnover and number of days sales in inventory. As an efficiency measure, inventory turnover measures the number of times a business entity sells and replaces its inventory, on average, within a year. It can be computed by dividing cost of goods sold by the average inventories. A high inventory turnover ratio may indicate efficient inventory management, while a low inventory turnover ratio may indicate poor inventory management. However, certain businesses, such as those that sell luxury goods, may typically have low inventory turnover.

For example, Charlie's Camper Company has a cost of goods sold of $600,000 and average inventory of $125,000. Its inventory turnover is 4.8, which means that the company is using and replacing its inventory, on average, 4.8 times per year.
As an important factor for creditors and investors, the number of days sales in inventory measures the number of days it takes a business, on average, to sell its inventory. Both the inventory turnover ratio and the number of days sales in inventory measure the efficiency inventory is managed, just in different terms. The inventory turnover shows how many times a year the total balance of inventory is used, on average, and days sales in inventory shows the same information, only in number of days. Number of days is a common way to measure performance, as it is a measure that is easy to understand and relate to. The number of days sales in inventory is an important financial measure because it gives investors and creditors insight into the value, liquidity, and cash flows of a business entity. The optimal goal is to have a short number of days sales in inventory, which would imply a liquid inventory. The number of days sales in inventory can be computed by dividing 365 days by inventory turnover. For example, Charlie’s Camper Company’s number of days sales in inventory is 76, which means that, on average, it takes the 76 days to use up the company’s inventory.

Accounts payable analysis ratios assess the frequency with which the organization pays what it owes to its suppliers. Accounts payable turnover measures how often accounts payable are paid, on average, within a year. The accounts payable turnover ratio can be computed by dividing total supplier purchases by the average accounts payable. For example, assume Charlie's Camper Company has total supplier purchases of $1,000,000 and average accounts payable of $250,000. The company’s accounts payable turnover is 4.0, which means that, on average, the accounts payable are paid in full 4.0 times per year. The days payable outstanding ratio measures the number of days, on average, it takes a business to pay its accounts payable. Both the accounts payable turnover ratio and the days payable outstanding measure the efficiency of the cash payables process, just in different terms. The accounts payable turnover shows how many times a year the total balance is paid out, on average. Days payable outstanding shows the same information, only in number of days. Number of days is a common way to measure performance, as it is a measure that is easy to understand and relate to. The days payable outstanding is a predictor of future cash outflows and allows the organization to ensure having adequate cash on hand to meet upcoming obligations. To illustrate, Charlie’s Camper Company’s average accounts payable is $250,000, and its average daily sales is $2,740 (with annual sales of $1,000,000). So, its days payable outstanding is 91 days, which means it takes the company 91 days on average to pay its accounts payable.