Ch.19 Evaluating performance: liquidity

What is liquidity?

The ability of a business to meet its short-term debts as they fall due.

What must be considered when assessing liquidity?

Both the level of liquid resources available and the speed at which those resources can be converted into cash to meet short-term debts.

What tools can be used to assess liquidity?

Trends, variances, benchmarks and liquidity/efficiency indicators.

What benchmarks can be used to assess liquidity?

Previous Periods, budgeted performance and similar businesses; some indicators also have specific benchmarks such as credit terms.

What indicators assess the level and speed of liquidity?

Level: Working Capital Ratio (WCR), Quick Asset Ratio (QAR) and Cash Flow Cover (CFC). Speed: Inventory Turnover (ITO), Accounts Receivable Turnover (ARTO) and Accounts Payable Turnover (APTO).

What does the Working Capital Ratio (WCR) measure and how is it calculated?

It measures current assets available per dollar of current liabilities. WCR = Current Assets ÷ Current Liabilities, expressed as x:1.

What does a WCR below or above 1:1 generally indicate?

Below 1:1 may indicate insufficient current assets to meet current liabilities; above 1:1 generally indicates satisfactory liquidity, although an excessively high ratio may indicate inefficient use of current assets.

Why can a WCR that is too high be undesirable?

It may indicate excess cash earning little return, excessive inventory creating storage/loss risks, or excessive Accounts Receivable including ageing debts.

Why should a bank overdraft be considered when interpreting WCR?

Although it is a current liability, unused overdraft capacity may provide an additional source of short-term cash.

What does the Quick Asset Ratio (QAR) measure and how is it calculated?

It measures the firm's immediate ability to meet current liabilities using quick assets. QAR = Current Assets excluding Inventory and Prepaid Expenses ÷ Current Liabilities, expressed as x:1.

Why are Inventory and Prepaid expenses excluded from QAR?

Inventory may not be sold quickly enough when cash is urgently needed, while prepaid expenses generally cannot be converted back into cash.

What does a satisfactory WCR but unsatisfactory QAR suggest?

The business has significant Inventory and/or Prepaid expenses and may depend heavily on selling inventory quickly to meet its debts.

What does Cash Flow Cover (CFC) measure and how is it calculated?

It measures how many times Net Cash Flows from Operating Activities can cover Average Current Liabilities. CFC = Net Cash Flows from Operating Activities ÷ Average Current Liabilities.

Why can CFC provide useful information beyond WCR and QAR?

WCR and QAR use Balance Sheet figures at one point in time, whereas CFC considers the actual cash generated from normal Operating activities during the Period.

What does Inventory Turnover (ITO) measure and how is it calculated?

It measures the average number of days taken to sell inventory. ITO = Average Inventory ÷ Cost of Goods Sold × 365.

How does ITO affect liquidity?

A lower number of days means inventory is sold faster, allowing cash from sales to be generated sooner and generally improving liquidity.

Why can ITO be too fast or too slow?

Too slow can delay cash inflows and increase inventory risks; too fast may indicate selling prices are too low or insufficient inventory is being held.

What does Accounts Receivable Turnover (ARTO) measure and how is it calculated?

It measures the average number of days taken to collect cash from Accounts Receivable. ARTO = Average Accounts Receivable ÷ Net Credit Sales including GST × 365.

How should ARTO be assessed?

Compare it particularly with the credit terms offered to customers; ARTO should generally be within those terms, while also considering previous periods and budget.

Why does faster ARTO generally improve liquidity?

Cash is collected from Accounts Receivable sooner and is therefore available earlier to meet short-term debts.

What does Accounts Payable Turnover (APTO) measure and how is it calculated?

It measures the average number of days taken to pay Accounts Payable. APTO = Average Accounts Payable ÷ Net Credit Purchases including GST × 365.

How should APTO be assessed?

Compare it particularly with suppliers' credit terms; the business should generally pay as close as possible to the due date without exceeding the terms.

What is the cash cycle relationship between ITO, ARTO and APTO?

ITO measures purchase → sale; ARTO measures credit sale → cash receipt; APTO measures credit purchase → payment. The business generally wants ITO and ARTO fast and APTO slower, while remaining within credit terms.

Why can a business survive with a low level of liquidity if turnover is fast?

If inventory is sold and cash is collected before debts must be paid, the business may still meet its obligations despite holding relatively few current assets.

What strategies can improve liquidity through ITO, ARTO and APTO?

ITO: increase sales or reduce excess/slow inventory. ARTO: credit checks, prompt invoices, reminders and early-payment discounts. APTO: use supplier credit terms effectively and communicate/pay on time.

Why should liquidity indicators not be analysed in isolation?

They measure different aspects of liquidity and may conceal individual problems, so they should be considered together with benchmarks, the cash cycle, detailed records and relevant non-financial information.