LOS 9

The Firm's Level of Aggregate Liquidity

Learning Outcome Statement (LOS)

What is aggregate liquidity? Why the measurement and management of

aggregate liquidity is important to the firm? Several aggregate liquidity measures Aggregate liquidity management in practice

Introduction

• Liquidity can be thought of as the firm’s ability to quickly generate cash versus the firm’s need for cash on short notice.

• However, a firm’s aggregate liquidity position indicates the overall relationship between total current assets (which provides cash inflows) and total current liabilities (which require cash outflows).

• If current assets can provide much more cash than is needed for current liabilities, then the chance of a cash stockout is lessened.

Why Measure and Manage Aggregate Liquidity?

• The amount of current debt relative to current assets affect the level of expected cash flows to shareholders and the risk of these cash flows.

• The management of aggregate liquidity starts with the measurement of the size of the hedge for various potential financial strategies.

• Since this management is facilitated by more precise measurement, the development and application of accurate measures of aggregate liquidity is of substantial advantage to the firm.

• However, the availability of accurate measures of aggregate liquidity has a side benefit.

Why Measure and Manage Aggregate Liquidity?

• In addition to the measurement of the firm’s own liquidity, measures of liquidity can also be applied to outside firms as an aid in making credit granting decisions.

• Aggregate liquidity is an important determinant of the probability of default, and the accurate assessment of this aggregate liquidity position can therefore lend important insights in estimating the default probabilities of credit applicants.

Traditional Measures of Aggregate Liquidity of a Firm

• Current Ratio

• Quick Ratio

• Accounts Receivable Turnover Ratio

• Inventory Turnover Ratio

Current Ratio

• This ratio shows the relationship between current assets and current liabilities and calculated as: Current assets/Current liabilities.

• This ratio is widely used by practitioners and has substantial intuitive appeal.

• An increase in this ratio indicates an increase in liquidity. However, if the ratio is increasing due to large increases in receivables or inventory, without a corresponding increase in sales, this may indicate problems rather than an increase in liquidity.

• The current ratio has a major weakness as an analytical tool. It ignores the composition of current assets, which may be as important as their relationship with current liabilities.

Quick Ratio

• This ratio relates current liabilities to only relatively liquid current assets (e.g., cash items and accounts receivable); also called acid-test ratio.

• Since the problem in meeting current liabilities may rest on slowness or even inability to convert inventories into cash to meet current obligations, the acid-test ratio is recommended.

• Acid-test ratio can be calculated as: (Current assets – Inventories – Accruals – Prepaid items)/Current liabilities.

Accounts Receivable Turnover Ratio

It is useful to analyze the quality (liquidity) of accounts receivable and one way to do this is to calculate how often they turn over, which implies an average collection period.

Accounts receivable turnover is computed as follows: Net Annual Sales/Average Receivables.

The faster these accounts are paid, the sooner the firm gets the funds that can be used to pay off its current liabilities.

However, a shorter collection period might indicate overly stringent credit terms (relative to competitors) that could hurt sales.

Accounts Receivable Turnover Ratio

By maintaining accounts receivable, firms are indirectly extending interest-free loans to their clients.

A high ratio implies either that a company operates on a cash basis or that its extension of credit and collection of accounts receivable is efficient.

A low ratio implies the company should re-assess its credit policies in order to ensure the timely collection of imparted credit not earning interest for the firm.

Inventory Turnover Ratio

• The ratio calculated by dividing cost of good sold (COGS) by average inventories.

• Like the A/R turnover ratio, the higher the turnover, the more liquid the asset.

• However, a very high inventory turnover and a very short processing time could mean inadequate inventory that could lead outages and slow delivery to customers, which would adversely affect sales.

• Again investors don’t want an extremely low turnover value and long processing time because this implies that capital is being tied up in inventory and could signal obsolete inventory.

Traditional Measures of Aggregate Liquidity of a Firm

• The four ratios discussed about are easy to understand and are commonly used in assessing the liquidity of firms.

• But as the discussion indicates, all are flawed to some extent as omnibus liquidity measures.

• They may give the wrong signals, contradictory signals, or no signals at all of actual changes in liquidity position.

Improved Measures of Aggregate Liquidity

• Cash Conversion Cycle (Richards and Laughlin)

• Comprehensive Liquidity Index (Melnyk and Birati)

• Net Liquid Balance (Shulman and Cox)

• Lambda Index (G. Emery)

Cash Conversion Cycle (CCC)

• CCC is the length of time from the payment for the purchase of raw materials to manufacture a product until the collection of A/R associated with the sale of the product, offset by the number of days payables outstanding.

• Usually a company acquires inventory on credit, which results in A/P. The company will then sell the inventory on credit, which results in A/R. Cash is therefore not involved until the company pays the A/P and collects A/R.

• So, the cash conversion cycle measures the time between outlay of cash and the cash recovery.

Cash Conversion Cycle (CCC)

• CCC is comprised of three standard, so-called activity ratios relating to the turnover of inventory, trade receivables and trade payables.

• These components of the CCC can be expressed as a number of times per year or as a number of days. Using the latter indicator provides a more literal and coherent time measurement that is easily understood.

• The CCC formula looks like this:

Days Inventory Outstanding (DIO) + Days Sales Outstanding (DSO) – Days Payable Outstanding (DPO) = CCC

Cash Conversion Cycle (CCC)

• Here's how the components are calculated:

• Dividing average inventories by cost of sales per day (cost of sales/365) = days inventory outstanding (DIO).

• Dividing average accounts receivables by net sales per day (net sales/365) = days sales outstanding (DSO).

• Dividing average accounts payables by cost of sales per day (cost of sales/365) = days payables outstanding (DPO).

Cash Conversion Cycle (CCC)

• CCC or the operating cycle is the analytical tool of choice for determining the investment quality of two critical assets - inventory and accounts receivable.

• CCC tells us the time (number of days) it takes to convert these two important assets into cash.

• A fast turnover rate of these assets is what creates real liquidity and is a positive indication of the quality and the efficient management of inventory and receivables.

• By tracking the historical record (five to 10 years) of a company's CCC and comparing it to competitor companies in the same industry (CCCs will vary according to the type of product and customer base), we are provided with an insightful indicator of a balance sheet's investment quality.

Comprehensive Liquidity Index (CLI)

• This is a liquidity-weighted version of the popular current ratio, weighting each current asset and liability based on its nearness to cash (its turnover).

• In computing CLI, the dollar amount of each current asset or liability is multiplied by one minus the inverse of the asset’s or liability’s turnover ratio. If there are more than two turnovers required to generate cash from the asset, the inverse of each of these ratios is deducted.

• The results are summed over all current assets and current liabilities.

• The summed totals are liquidity-adjusted measures of total current assets and total current liabilities.

Comprehensive Liquidity Index

• The current ratio is then computed based on these adjusted figures; in the notation of Melnyk and Birati, X is the adjusted total current assets figure and Y is the adjusted total current liabilities figure.

• The Comprehensive Liquidity Index (CLI) is just X divided by Y.

Net Liquidity Balance

• This index measures center on the firm’s balance of cash and marketable securities.

• This index represents the firm’s true reserve against unanticipated cash needs, since other remedies for cash shortages can be very costly.

• The Net Liquidity Balance does not view the firm’s investment in A/R and inventory as contributions to aggregate liquidity, but, rather, considers them as additional assets to be financed.

Net Liquidity Balance

• The A/P and accruals that are part of current liabilities are treated not as maturing obligations but as part of the firm’s permanent financing package (similar to long-term debt).

• Only notes payable (short-term, interest-bearing debts) are treated as maturing obligations.

• The Net Liquid Balance (NLB) is defined as: NLB = (Cash + Marketable Securities – Notes Payable)/Total Assets.

Lambda

• The Lambda Index uses the cash flow uncertainty along with the level of the firm’s initial reserve and the expected future cash flows to generate an index akin to a Z-score.

• The formula is: Lambda = (Initial Reserve + E(NCF))/Uncertainty.

• Here, • Initial reserve = Cash + Marketable securities + Available

credit line• E(NCF) = The expected cash flow and • Uncertainty = The standard deviation of these cash flows

Lambda

• Lambda is different from the Net Liquid Balance in four respects:

• Lambda considers the firm’s available credit line as pat of the firm’s package of liquid reserve.

• Lambda uses a measure of uncertainty to evaluate the firm’s potential need for liquidity.

• Lambda is the only measure that incorporates the firm’s expected cash flows in addition to its cash and near-cash stocks of assets.

• Lambda considers all the cash flows through the firm, regardless of whether they originate from short-term to long-term transactions.

Some Caveats Regarding Liquidity Measures

• While all four of these measures are improvements, no index of this sort will completely measures the aggregate liquidity.

• Two problems in the liquidity measurement that are not addressed by these new indices concern

• the effect of off-balance sheet relationships and • the treatment of current long-term debt

Evaluating Strategies for Aggregate Liquidity

• The use of relatively more short-term debt and less long-term debt is a higher risk and higher expected return liquidity strategy.

• This is due to the way the division of total debt affects the firm’s

• expected level of interest payments• variability of interest payments• cash shortage risk

Expected Level of Interest Payments

• The use of more permanent, short-term debt and less long-term debt will generally reduce the firm’s cash outflows for interest expense.

• There are two reasons for this reduction.

• The interest rate on short-term debt are usually lower than the interest rates on long-term debt (that is, yield curve is upward slopping)

• If the firm is in a business where seasonality affects its need for funds, and it uses a relatively large proportion of long-term debt financing, there may be times during which the firm has excess financing, which they will invest in short-term instruments with lower interest rates.

Variability of Interest Payments

• One source of risk in using short-term financing is the changeable nature of short-term interest rates.

• Minimum-cost, short-term financing strategies for firms often involve the use of interest-bearing obligations, which is subject to interest rate variability.

• Further, if monetary conditions become such that the yield curve becomes downward slopping, the strategy of using more short-term and less long-term financing will result in a higher interest outflow.

Cash Shortage Risk

• The higher the short-term borrowings, all other things being equal, the more principal to be refinanced, and consequently, the higher the firm’s average inflows and outflows of cash.

• And the higher the required cash outflows, the greater the chance that a difficulty with inflows will cause a financial crisis and that a financially painful solution (such as dividend reduction, rushed liquidation of assets, unplanned borrowing) will be needed.

• This cash shortage risk is measured by the indices of aggregate liquidity discussed earlier.

Liquidity Management in Practice

• Smith and Sell (1980) found in a study of Fortune listing of firms that

• 22% of the firms indicated that they had a cautious (high liquidity) working capital policy

• 28% indicated that they had an aggressive (low liquidity) policy• the remaining 50% indicated that they changed policy over time.

• Ratios used to assess liquidity position (in order of popularity) were

• The current ratio• The working capital turnover ratio (Sales divided by Net working

capital)• Working capital as a percentage of total assets

Liquidity Management in Practice

• Where Smith and Sell investigated the types of tools and policies used by firms, Johnson, Campbell, and Wittenback were primarily concerned with the importance of several tools in the management of liquidity.

• In another study, Johnson, Campbell, and Wittenback (1980) found that the most popular objective of liquidity management was to meet temporary financial problems as they arise.

• They also found that measures of aggregate liquidity were more important to firms relative to this objective mostly during periods when the firm was having liquidity difficulties.

Liquidity Management in Practice

• Gilmer found that the optimal level of liquid assets varied among industries and over time.

• Gardner and Mills found the level of current liabilities to be associated with the level of assets and the firm’s industry.

• Another interesting result of these empirical investigations is that firms’ aggregate liquidity positions have been declining over time. Gardner and Mills cite such evidence using the quick and current ratios as liquidity measures.

• Belt finds the same trend when using the cash conversion cycle as measure of aggregate liquidity.