In last weeks column on company fundamentals the various aspects of debt were explored.   In this week’s article the liquidity of a company will be explained.

While debt and liquidity are closely related, they are not in fact the same thing.  For example, a company with little debt may still have major cash flow problems leading to its creditors instituting claims against it.

Liquidity is extremely important for a number of reasons.

Firstly, a highly liquid company is more able to respond to changes in the environment, opportunistic acquisitions, and/or any other cash-intensive needs.

Secondly, working capital has a cost associated with it (i.e. the cost of funding it), which a highly liquid company minimises.  This allows it to have expanded profits margins and a healthier ability to leverage itself.

Thirdly, illiquidity can actually even lead to financial distress of a company.  With no cash in the bank, debtors not paying, and creditors baying at the gates…even a debt-free company is going to have problems (continuing) operating.

Finally, liquidity and many of the liquidity ratios give a good indication of how good management is at running the business on a day-to-day basis.  One of the first warning signs of bad management is worsening company liquidity.  This then leads the company down a path of possibly borrowing to pay creditors, bringing on debt that it then has to service and things can go very wrong from that point onwards…

Besides a careful inspection of a company’s balance sheet and its cash balance, some of the more important ratio’s that are used to measure a company’s liquidity are the following:

•    Current Ratio: Total Current Assets / Total Current Liabilities
  o    This ratio shows how many liquid assets the company has to set off against the amounts currently owing by it
  o    At a bare minimum this ratio is above “1” where assets cover the liabilities

•    Quick Ratio (also known as the Acid Test Ratio): (Total Current Assets excluding Inventory) / Total Current Liabilities
  o    This ratio is the same as the Current Ratio, but assumes the worst case scenario for a company where it cannot sell any of its stock.
  o    This ratio should also be above “1” where the non-stock assets cover the liabilities

•    Debtors Days or Debtors Collection Period: 365 / (Turnover / Debtors)
  o    This ratio shows how many days the average debtor takes to pay
  o    The smaller (i.e. the less time from the date of the sale to the date of receiving payment) the better, as debtors have an implied financing costs for the company awaiting payment.

•    Stock Turnover: 365 / (Cost of Sales / Stock)
  o    This ratio shows how many days the average item of inventory takes before it is sold.
  o    The smaller (i.e. the less time that it takes to buy/produce an item of stock and then resell it) the better, as carrying excessive amounts of stock has a lot of carrying and financing costs associated with it

•    Cash-to-Profits Ratio: Operating Cash Generated per Share / EPS
  o    A little known ratio, but one that I find incredibly useful, as it reveals how much cash a company can generate in proportion to the amount of its reported accounting profits.
  o    Beware those companies showing massive accounting profits, but no or negative operating cash flows…  These are just problems waiting to happen.

In conclusion, liquidity is a critical fundamental element to inspect in making an investment decision.  The above broad ratios allow valuable insight into any company’s liquidity that should serve as a good start for further scrutiny.

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