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Short-Term Liquidity

Category: Financial Control Management

The short-term liquidity of an enterprise is measured by the degree to which it can meet its short-term obligations.

A lack of liquidity leads to:

Implies a lack of freedom of choice as well as constraints of management’s freedom of action;

The forced sale of long-term investments and assets and, in the most severe form, t insolvency and bankruptcy;

Reduced profitability and opportunity or it my mean loss of control and partial or total loss of the capital investment;

Delays in collection of interest and principal due them or it can mean the partial or total loss of the amounts due them;

Inability of the enterprise to perform under contracts and the loss of supplier relationship.

If an enterprise cannot meet its current obligations as they become due, its continued existence becomes doubtful and that relegates all other measures of performance to secondary importance if not to relevance.

One widely used measure of liquidity is Working Capital. In addition to its importance as a pool of liquid assets that provides a safety cushion to creditors, Net Working Capital is also important because it provides a liquid reserve with which to meet contingencies and the ever-present uncertainty regarding an enterprise’s ability to balance the outflow of cash with an adequate inflow of cash. This concept is illustrated in the Working Capital Management section.

Short-Term Liquidity Ratios

Current Ratio measures the degree to which current assets cover current liabilities. The higher the amount of current assets in relation to current liabilities, the greater the assurance that these liabilities can be paid out of such assets. The excess of current assets over current liabilities provides a buffer against losses that may be incurred in the disposition or liquidation of the current assets other than cash. The more substantial such a buffer is, the better for creditors. Thus, the current ratio measures the margin of safety available to cover any possible shrinkage in the value of current assets.

The Current Ratio can be expressed as:

The Current Ratio

In the financial practices the Quick Ratio (acid-test) and the Quick Ratio (receivables) is widely used. These ratios measure the degree to which cash and cash equivalents, and respectively cash and accounts receivables cover current liabilities.

What is not so obvious, however, is the fact that liquidity ratios, as a measure of liquidity and short-term solvency, is subject to serious theoretical as well as practical shortcomings and limitations:

The liquidity ratios are «static» concepts of what cash resources are available at a given moment in time to meet the obligations at that moment. The existing reservoir of cash resources does not have a logical or causative relationship to the future cash that will flow through it;

The future flows depend importantly on elements not included in the ratio itself, such as sales, cash costs and expenses, profits, and changes in business conditions;

When looking at accounts receivable as a source of cash, we must, except in the case of liquidation, recognize the revolving nature of the asset with the collection of one account replaced by the extension of fresh credit;

The determination of future cash inflows through the sale of inventories is dependent on the profit margin that can be realized because inventories are generally state at the lower of the cost or market;

The level of accounts receivable and inventories depends mostly on prospected sales as apposed to the present level of those;

Liquidity depends to some extent on cash or cash equivalents balances an to a much more significant extent on perspective cash flows;

There is no direct or established relationship between balances of working capital items and the pattern that future cash flows are likely to assume. Managerial polices directed at optimizing the levels of receivables and inventories are oriented primarily toward efficient and profitable assets utilization and only secondarily at liquidity;

The use and the appropriate interpretation of liquidity ratios is a matter of analyst’s objectives and of its abilities to highlight particular areas of interest.

In order to reduce the limitations of liquidity ratios and to provide a proper shape of the analysis, the following additional aspects have to be analyzed:

Index-number trend of the Working Capital components (horizontal analysis);

Common-size analysis of the Working Capital, by means of which the composition of the current assets group is examined over time (vertical analysis);

Comparison of the Working Capital trends and liquidity ratios;

The analyst must be aware of the possibilities of year-end manipulation of the current ratio, otherwise known as window dressing;

Analysis of the Cash Flow Ratio and of Net Trade Cycle.

Cash Flow Ratio

Since liabilities are paid with cash, the relationship of cash provided by operations to current liabilities is significant. The ratio of Operating Cash Flow to current liabilities overcomes the weakness of tee static current ratio in that its numerator represents a flow over time.

The Cash Flow Ratio is computed:

The Cash Flow Ratio is computed

The ratio measures the ability of the company to meet its maturing obligations out of cash provided by operations. It is computed for a period of 5 to 7 years. Empirical studies determined that a ratio of operating cash flow to current liabilities of 0.4 is common for healthy businesses.

Net Trade Cycle / Operational Cycle

An enterprise’s need for working capital depends importantly on the relative size of its required inventory investment as well as on the relationship between the credit terms it receives from its suppliers as against those it must extend to its customers.

The Net Trade Cycle represent the turnover period of Working Capital. The higher the Net Trade Cycle the larger the investment in working capital required. A reduction in the number of days sales in receivables or cost of sales in inventories will lower working capital requirements. An increase in the days of purchases credit received from suppliers will have a similar effect.

The formula is:


The consideration and the description of the Net Trade Cycle is illustrated in the Working Capital Management section.

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