Discusses the four measures for assessing short-term liquidity risk

Answer 1

MEASURES OF SHORT-TERM LIQUIDITY RISK

Four measures for assessing short-term liquidity risk are (1) Current ratio, (2) Quick ratio, (3) Cash flow from operations to current liabilities ratio, and (4) Working capital turnover ratios.

Current Ratio

The current ratio equals current assets divided by current liabilities. Current assets comprise cash and assets that a firm expects to turn into cash or sell or consume within approximately one year of the balance sheet date. Current liabilities include obligations that will require cash (or the rendering of services) within approximately one year. Thus, the current ratio indicates a firm's ability to meet its short-term obligations. Analysts prefer a current ratio that at least exceeds 1.0 .

Changes in the trend of the current ratio can mislead. For example, when the current ratio exceeds 1.0, an increase of equal amount in both current assets and current liabilities (by acquiring inventory on account) results in a decline in the ratio, whereas equal decreases (by paying an accounts payable) result in an increased current ratio.

In a recessionary period, a business may contract and use cash, a current asset, to pay its current liabilities. When the current ratio exceeds 1, such action will increase it. In a boom period, firms sometimes conserve cash by delaying payment of current liabilities, causing the reverse effect. Thus, a high current ratio may accompany deteriorating business conditions, whereas a falling ratio may accompany profitable operations.

Furthermore, management can take deliberate steps to produce a financial statement that presents a better current ratio at the balance sheet date than the average, or normal, current ratio during the rest of the year. For example, near the end of its accounting period a firm might delay normal purchases on account. Or, it might hasten the collections of a loan receivable, classified as noncurrent assets, and use the proceeds to reduce current liabilities. Such actions will increase the current ratio. Analysts refer to such actions as window dressing.

Quick Ratio

A variation of the current ratio is the quick ratio (sometimes called the acid test ratio). The quick ratio includes in the numerator of the fraction only those current assets that a firm could convert quickly into cash. The numerator customarily includes cash, marketable securities, and accounts receivable. Some businesses can convert their inventory of merchandise into cash more quickly than other businesses can convert their receivables. The facts in each case will indicate whether the analyst should include receivables or exclude inventories. The denominator includes all current liabilities. A quick ratio approximately one-half of the current ratio is typical, although this varies by industry.

The general rule is that adding equal amounts to both the numerator and the denominator of a fraction moves that fraction closer to the number 1, whereas subtracting equal amounts from both the numerator and the denominator of a fraction makes that fraction diverge from the number 1 . To be even more general, adding a to (subtracting a from) the numerator while adding b to (subtracting b from) the denominator of the fraction makes the fraction converge to (diverge from) the fraction a/b.

Cash Flow from Operations to Current Liabilities Ratio

Some analysts criticize the current ratio and the quick ratio to measure short-term liquidity risk because these ratios use balance sheet amounts at a specific time. If financial statement amounts at that time are unusually large or small, the resulting ratios will not reflect normal conditions. If management knows that analysts will evaluate the firm using one of these ratios at a particular time, it can take steps to window dress that ratio by, for example, using cash to pay off a current liability (reducing both numerator and denominator) or acquiring inventory on account (increasing both numerator and denominator).

The cash flow from operations to current liabilities ratio overcomes these deficiencies. The numerator of this ratio is cash flow from operations for the year. The denominator is average current liabilities for the year. Healthy mature firms typically have a ratio of 40% or more.

Working Capital Turnover Ratios

During the operating cycle, a retailing firm (1) purchases inventory on account from suppliers, (2) sells inventory for cash or on account to customers, (3) collects amounts due from customers, and (4) pays amounts due to suppliers. This cycle recurs for most businesses. The number of days that a firm holds inventories (that is, 365 days/inventory turnover ratio) indicates the length of the period between the purchase and the sale of inventory during each operating cycle. The number of days that a firm's receivables remain outstanding (that is, 365 days/accounts receivable turnover ratio) indicates the length of the period between the sale of inventory and the collection of cash from customers during each operating cycle. Firms must finance their investments in inventories and accounts receivable. Suppliers typically provide a portion of the needed financing. The number of days that a firm's accounts payable remain outstanding (that is, 365 days/accounts payable turnover ratio) indicates the length of the period between the purchase of inventory on account and the payment of cash to suppliers during each operating cycle. The accounts payable turnover ratio equals purchases on account divided by average accounts payable. Although firms do not disclose their purchases, the analyst can derive the amount as follows:

Beginning Inventory + Purchases = Cost of Goods Sold + Ending Inventory
Rearranging terms yields the following:
Purchases = Cost of Goods Sold + Ending Inventory - Beginning Inventory

Interpreting the accounts payable turnover ratio involves opposing considerations. An increase in the accounts payable turnover ratio indicates that a firm pays its obligations to suppliers more quickly, requiring cash and even wasting the benefits of cash if the firm makes payments earlier than necessary. On the other hand, a faster accounts payable turnover means a smaller relative amount of accounts payable that the firm must pay in the near future. Most firms want to extend their payables as long as they can, but they also want to maintain their relations with suppliers. Businesses, therefore, negotiate hard for favorable payment terms and then delay paying until just before the last agreed moment.