Financial Ratios: Liquidity Measurement

Finally, here comes the technical aspect of value investing. It is important to note that from now on, content will be highly abstract, which will require moments of pausing to comprehend what you've just read. It takes great effort to understand the formulas of the different ratios, and just simply quoting them blindly in your research won't do you any good. This is simply the first part of financial ratios where we look into the ability of a company to pay off its short term liabilities by comparing the company's more liquid assets to its liabilities.




There will be other financial ratios to look into such as profitability ratios, debt ratios, operating performance ratios, cash flow indicator ratios and investment valuation ratios.

Although it is important to go through all these ratios, you may also need to take into account other factors like management, background of the company, insider activity and many more (these factors cannot be calculated with formulas. However, we can evaluate these factors through careful scrutiny of the company's annual reports).


REMEMBER, VALUE INVESTING IS ALL ABOUT DILIGENCE AND PATIENCE. 

YOU REAP WHAT YOU SOW!

DON'T BE LAZY AND SIMPLY RELY ON 1 OR 2 RATIOS TO MAKE YOUR INVESTMENT DECISIONS. 

YOU WILL REGRET IT.

 
 

Contents:

1. Current ratio
2. Quick ratio
3. Cash Conversion cycle

Current Ratio

The most basic liquidity indicator that gives investors a clue on whether a company's current assets (eg. cash, cash equivalents, marketable securities, receivables and inventory) are readily available to clear its short-term debts.

Formula:

Limitations:

• It does not take into account the duration of converting the company's assets into cash.
• If it takes very long to convert the company's assets into cash, the company is highly non-liquid, and the figure of this ratio may be "misleading". 
• Company ABC can have a current ratio of 3.0 (its current assets are 3 times more than its current liabilities!) However, if these assets takes 5 years to convert into cash, in the short run the company may not be able to clear its debt - You can only clear liabilities with cash (IMPT CONCEPT).

Quick Ratio

A stricter liquidity ratio (compared to the current ratio) that only involves the most liquid current assets there are to cover current liabilities. Therefore, a higher ratio means a more liquid current position. 

Formula:

Limitations:

• Similar to the current ratio, it does not take into account the duration of converting the company's assets into cash. 
• However, the problem is reduced as we are only including the company's more liquid assets in the formula.

Cash Conversion Cycle
Preface: This is very difficult to understand. It takes me many days to digest this concept. However, this is the most important liquidity measurement compared to the current ratio and the quick ratio.

The Cash Conversion Cycle (CCC) expresses the duration that of a company to convert its inventory  into sales and subsequently into cash. The shorter the duration, the more liquid the company is and the safer the position of the company is; after all, the company has no problems meeting its short-term obligations. 

Ultimately, the CCC is the solution to the limitations of the current and quick ratios!

Note: The duration is measured in number of days

Formula:

Now here is the most challenging concept in this post. Take a moment to understand each formula carefully. Each components (DIO, DSO and DPO) have their own respective formula.

Days inventory Outstanding = 

Avg. Inventory (Average of the previous year-end and this year's ending inventory figure)

---

Cost of goods sold / 365

The denominator can also be represented as cost of goods sold per day.

Example: 

Total cost of goods sold for the year: $200000

Cost of goods sold per day = $200000/ 365 = $547.94

Previous year-end inventory figure = $300000

Current year-end inventory figure = $280000

Average accounts receivables = $290000

Days Sales Outstanding = 290000/547.94 = 529 (3 s.f)

Conclusion: It takes approximately 529 days for the company to turn over (or liquidate) its entire inventory, and in most cases, this is considered highly non-liquid.

Days Sales Outstanding =

Average Accounts Receivables (Average of the previous year-end and this year's end account receivables figure)

---

Net annual sales / 365

The denominator can also be represented as net sales per day.

Example: 

Net Sales for the year: $100000

Net sales per day = $100000/ 365 = $273.97

Previous year-end account receivables = $300000

Current year-end account receivables = $280000

Average accounts receivables = $290000

Days Sales Outstanding = 290000/273.97 = 1058 (4 s.f)

Conclusion: It takes approximately 1058 days for a company to collect its annual sales that go into accounts receivables (credit purchases). Again, highly non-liquid. Can you imagine it takes about 3 years to simply collect the year's sales revenue??

Day Payables Outstanding =

Average Accounts Payable (Average of the previous year-end and this year's end accounts payable figure)

---

Cost of sales / 365

The denominator can also be represented as net sales per day.

Example: 

Cost of sales for the year: $500000

Cost of sales per day = $500000/ 365 = $1369.86

Previous year-end account payables = $200000

Current year-end account payables = $100000

Average accounts payables = $150000

Days Sales Outstanding = 150000/1369.86 = 110 (3 s.f)

Conclusion: It takes approximately 110 days for the company to pay its obligations to its suppliers. Please note that a low figure is not necessarily better, if not worse. 

Although the DPO shows how long it takes for a company to pay back its suppliers, the days payable outstanding also shows how long a company can make interest on the money made. The larger the DPO, the better.  This is because the larger the number, the more interest the company is able to earn by placing their money in the bank.  

That is why in the CCC formula, the DPO is subtracted from the sum of DSO and DIO rather than added.

Applying the CCC formula, we have 529 + 1058 - 110 = 1477

Remember the definition of CCC? So what is the significance of this number? 

Answer: It takes 1477 days to convert its inventory  into sales and subsequently into cash. 

Conclusion:

We have looked into 3 important liquidity measurement ratios, the most important one being the cash conversion cycle. There are many other liquidity measurement ratios, but many are similar to these ratios. However, obviously we can't simply measure a company's liquidity and base our investment decisions on its liquidity alone. We will be looking into other ratios in the subsequent posts such as profitability ratios, debt ratios, operating performance ratios, cash flow indicator ratios and investment valuation ratios. Meanwhile, thank you for your time in reading this post.

Have a great day ahead.

Acknowledgements:

http://accounting-financial-tax.com/2008/11/liquidity-measurements-ratio-formula/

http://accountingexplained.com/financial/ratios/

http://www.mysmp.com/fundamental-analysis/days-payable-outstanding.html

http://www.investopedia.com/