Liquidity - Sources and Measurements

  • Working Capital Management ensures that the company is having sufficient funds to finance its day to day activities. Liquidity is the extent to which the company can convert its assets to cash to meet its day to day expenses. Hence, Working Capital Management ensures that the company is having sufficient Liquidity to manage its operations.

Sources of Liquidity

There are various sources through which company raises funds to maintain the liquidity, they may be grouped in the following categories:
  • Primary Source: These are the most liquid sources that may be immediately converted to cash. Primary sources of liquidity do not impact the financial position and operations of the company. These include:
Primary Source
Cash Balance Short-Term Funding Cash Flow Management
  • Cash from Sales 
  • Cash from the collection of receivables 
  • Cash from Short-Term investments
  • Working Capital Advance from Bank 
  • Trade Credit from Suppliers
  • Cash through efficient cash flow management
  • Secondary Source: These sources affect the financial and operational health of the organization as they are not a part of the company’s regular sources of cash. These include:
Secondary Source
Negotiating the Existing Debt: This helps to reduce/restructure payments of interest/principal to increase immediate liquidity in the organization.
Liquidating Assets: This includes liquidating short -term and long-term assets to increase the liquidity in the organization
Bankruptcy: This is the last possible resort to increase liquidation in the organization.

Drags and Pull-on Liquidity

  • When there are delays in the receipts of payments, it is referred to as Drag-on Liquidity. This includes uncollected receivables, obsolete inventory, and tight credit.
  • When the disbursements are paid too quickly, it is referred to as Pull-on Liquidity. This includes making early payments, reduced credit limits, reduced line of credit from banks.

Measuring Liquidity

There are various ways to measure liquidity which can be grouped into the following categories:
  1. Liquidity Ratios: These ratios are used to measure the company’s ability to fulfil its short-term fund requirements.
  2. Turnover Ratios: These ratios are used to determine the operational efficiency of a company. It tells how well a company is using its resources to maximize the output.
  3. Miscellaneous:
Liquidity Ratio Turnover Ratio Miscellaneous
  • Current Ratio
  • Quick Ratio
  • Accounts Receivable Turnover Ratio
  • Inventory Turnover Ratio
  • Number of Days Receivable 
  • Number of Days Payable 
  • Number of Days of Inventory. 
  • Operating Cycle 
  • Net Operating Cycle

Liquidity Ratio

Current Ratio: 

  • It determines a company’s capacity to meet its short-term liabilities/debts. This ratio is also known as Working Capital Ratio.
Current Ratio  = Current Assets
Current Liabilities

Quick Ratio: 

  • It determines a company’s capacity to meet its short-term liabilities/debts with quick/most liquid assets. This ratio is also known as the Acid Test Ratio.
Quick Ratio  = Quick Assets
Current Liabilities
Where,
Current Assets are those assets that can be liquidated or converted to cash within a year
Quick Assets are those assets that can be converted quickly into cash, the quick asset is also known as Liquid Assets.
Current Liabilities are the liabilities or debts that are due for payment within a year.

Turnover Ratio

Accounts Receivable Turnover Ratio: 

  • It determines the efficiency with which a business is using its assets.
Account receivable Turnover Ratio   = Net Credit Sales
Average Account Receivable

Inventory Turnover Ratio: 

  • It determines how many times in a year the inventory has been turned/sold.
Inventory Turnover Ratio   = Cost of Goods Sold
Average Inventory
Where,
Net Credit Sales = Total Sales During the Period (Excluding Sales Returns, Sales Allowances, and Sales for which payment is received in Cash)
Cost of Goods Sold = Inventory at the Beginning of Period + Purchase – Inventory at the End of Period.
Average Inventory    = Opening Inventory + Closing Inventory
2

Miscellaneous

Number of Days Receivable: 

  • This gives an idea about the average number of days taken to receive the receivable by a company. This is also known as day’s sales outstanding or days in receivable.
Number of Days of Receivable   = Average Accounts Receivable
Average Day's Sales on Credit
Average Day's Sales on Credit   = Sales on Credit
365

Number of Days of Inventory: 

  • This is the average time duration for which the inventory remains within the company. This is also known as the Average Inventory Period or Days’ Sales in Ending Inventory or Inventory Holding Period.
Number of Days of Inventory = Average Inventory
Average Day's Cost of Goods Sold
Average Day's Cost of Goods Sold  = Cost of Goods Sold
365

Number of Days of Payables: 

  • This gives an idea of how fast a company pays off its dues. This is also known as Day’s Payable Outstanding or Average Days Payable.
Number of Days of Payables  = Average Accounts Payable
Average Day's Purchase
Average Day's Purchase   = Purchases
365

Operating Cycle: 

  • This is the time required to convert raw materials into sales and finally into cash. This is also known as Net Operating Cycle or Cash Conversion Cycle.
Operating Cycle = Number of Days of Inventory + Number of Days Receivables

Net Operating Cycle: 

  • This is the time required to convert raw materials into sales and finally into cash taking into concern the payment to suppliers. This is also known as the Cash Conversion Cycle.
Net Operating Cycle = Number of Days of Inventory + Number of Days of Receivables - Number of Days of Payables

 Significance

Method High Value Low Value
Current Ratio Good Bad
Quick Ratio Good Bad
Accounts Receivable Turnover Ratio Good Bad
Inventory Turnover Ratio Good Bad
Number of Days Receivable Bad Good
Number of Days of Inventory Good Bad
Number of Days of Payables Bad Good
Operating Cycle Bad Good
Net Operating Cycle Bad Good
  • The significance of the methods given above is just indicative and not the final deciding mechanism, the values differ for every sector of industry and every type of business, hence they should only be used for indicative purposes.
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