Liquidity

Liquidity refers to how quickly a company can convert assets into cash to meet short-term obligations. A major responsibility of corporate financiers is liquidity management, or the organization and generation of cash funds to satisfy operating needs.

Primary sources of liquidity include:

Cash
Short-term funds (trade credit, bank lines of credit, short term investments, etc.)
Other assets converted into cash under the cash flow management system

Secondary liquidity sources materially affect a company's operations. They include:

Debt contract renegotiation
Asset liquidation
Bankruptcy protection

A firm's creditworthiness is directly related to their level of liquidity. Liquidity ratios represent a primary source of measuring a firm's ability to convert assets into cash. Commonly used liquidity ratios are:

Current ratio: The broadest measure of assets and liabilities.

Current ratio = (Current Assets) / (Current Liabilities)

Quick ratio (Acid-test ratio): Measures quick assets, or those that can most readily be converted into cash, against liabilities. The quick ratio excludes inventory.

Quick ratio = (Cash + Short-Term Marketable Securities + Receivables) / (Current Liabilities)

Cash ratio: The strictest measure of liquidity, measuring cash against current liabilities.

Cash Ratio = (Cash) / (Current Liabilities)

Accounts receivable turnover: Measures the ratio of sales on credit against average accounts receivables.

Accounts Receivable Turnover = Sales / (Average Receivables)

Inventory turnover: Measures the total value of goods sold to the inventory balance.

Inventory Turnover = (Cost of Goods Sold) / (Average Inventory)

Number of days of receivables (Day's sales out-standing): Measures the value of credit extended to and collected from customers.

Number of days of receivables = (Receivables) / (Sales / 365)

Number of days of inventory: Measures how well inventory is being managed.

Number of days of inventory = (Inventory) / (Cost of goods sold /365)

Number of days of payables: Measures the time period in which a company pays its suppliers.

Number of days of payables = (Payables) / (Purchases / 365)

Operating cycle: Measures the time needed to convert resources into goods and subsequently sold to customers.

Operating cycle = (# of days inventory) + (# of days receivables)

Net operating cycle (cash conversion cycle): Measures the total time goods and services are in the operating cycle, minus outstanding payments from credit clients.

Cash conversion cycle = (# days receivables) + (# of days inventory) - (# days payables)

Financial Terms by BetterTrades