Reading 23: Liquidity Measures and Management

Book 1: Corporate Issuers

Cash Conversion Cycle

measures the efficiency of a company’s cash flows

Representation of CCC—How it actually happens

Cash —> purchase materials —> Accounts Payable —> manufacturing —> Inventory —> Sales —> Accounts Receivables —> Collections —> Cash

What’s better, lower CCC or higher CCC?

Lower CCC, converting sales to cash quicker

How can a firm improve CCC?

Decrease inventories

Decrease accounts receivables

Increase accounts payables

What’s the downside of decreasing inventories and accounts receivables?

May not be able to meet consumer demand

Can create bottlenecks in supply chain

What is accounts payable at a more rudimentary level?

It is a form of supplier lending. They let a firm delay payment for inputs and thus the firm gets a loan.

a/b net c; 2/10 net 30

A firm gets a 2% discount if paid in 10 days, otherwise, payment due in 30 days

Working Capital

how efficiently a company manages its liquidity

How do analysts compare working capitals of different companies with different sizes?

WC margin

Liquidity

an assets nearness to cash; a liabilities nearness to settlement

Which is more liquid: accounts receivable or inventory?

Accounts receivable

Depends on what kind of inventory, who you are selling to, etc.

Accounts receivable is required to be collected within a certain timeframe whereas the economic landscape can dictate the conversion of inventory

Primary Liquidity Sources

Cash

Marketable Securities

Bank Borrowings

Secondary Sources of Capital

Cash saved by suspending dividends

Delaying or reducing capital investments

Selling assets

Issuing additional equity

Restructuring debt to extend its maturity

Bankruptcy protection filing, suspends the need to service the liabilities

Which sends a negative signal to the market: Primary or Secondary Sources of Liquidity?

Secondary

How do you find the cost of liquidity?

Liquidation Cost/Total Fair Market Value

What increases CCC?

Drag on Liquidity

Pull on Liquidity

Drag on Liquidity

when cash inflows lag; DOH or DSO increases

Pull on Liquidity

when cash outflows accelerate

Conservative Approach to Managing WC and Liquidity

More short-term assets

Finance WC using long-term debt and equity

• Less rolling over required

Downside of the Conservative Approach

Lower profitability and minimum interest coverage ratio

Minimum Interest Coverage Ratio

a covenant the requires a firm to hold a specific amount of earnings to pay interest payments

Aggressive Approach to Managing WC and Liquidity

Hold lower amount of short-term assets

Finance WC through short-term debt

• Less spent on assets and ability to roll forward

Downside of Aggressive Approach

failure to meet business obligations, prone to market disruptions

Moderate Approach to Managing WC and Liquidity

Permanent current assets are funded using long-term sources of capital

Seasonal current assets are funded using short-term debt

Factors that affect a firm’s willingness to take on short-term liquidity sources

Company Size

Creditworthiness

Legal systems

Regulatory changes

Underlying assets (collateral)