- CFA Exams
- 2024 Level I
- Topic 4. Corporate Issuers
- Learning Module 32. Working Capital & Liquidity
- Subject 3. Defining Liquidity Management
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Subject 3. Defining Liquidity Management PDF Download
Liquidity refers to the ability of a company to satisfy its short-term obligations using assets that can be readily converted to cash. Liquidity depends on both the type of asset and the speed at which it can be converted to cash.
Even though long-term assets may also be converted to cash to improve liquidity, it has other costs for a company, for example, it may impair a company's financial strength.
There are two sources of liquidity. The main difference between the two sources is whether or not the company's normal operations will be affected.
- Primary sources of liquidity include cash, short-term funds, and cash flow management. These resources represent funds that are readily accessible at relatively low cost.
- Secondary sources include negotiating debt contracts, liquidating assets, and filing for bankruptcy and reorganization. They provide liquidity at a higher price and may impact a company's financial and operating positions.
Drags and Pulls on Liquidity
The timing of cash receipts and disbursements can significantly affect a company's liquidity position.
A drag on liquidity exists when cash inflows lag.
- Uncollected receivables: For an analyst, the drags are often visible from an analysis of balance sheet trends and ratios. For example, a deterioration in days sales outstanding (DSO) is often an indication of negative developments acting as drags on liquidity. Increasing levels of bad debt expenses are also a useful indicator to identify issues in the collection of receivables.
- Inventory obsolescence: If a company's inventory is turning obsolete, it will experience a drag on liquidity as the value of such inventory declines, turning into lower cash inflows than planned. A good indication of increasing inventory obsolescence is often given by slowing inventory turnover ratios.
- Tight credit: If access to capital worsens or becomes more expensive, a company's liquidity may worsen.
A pull on liquidity is generated when cash outflows happen too quickly or when a company's access to commercial or financial credit is limited.
- Early payments: A company that pays its suppliers, creditors, or employees before the payment is due is creating a pull on liquidity. It is a commonplace among companies to hold payments until the due date without any anticipation of payments.
- Reduced credit limits: Consider a company fails to pay its obligations to its suppliers on a timely basis, or willingly takes advantage of its suppliers by paying after a long delay. In such cases, suppliers may decide to reduce the amount of trade credit to the company - impacting its liquidity.
- Reduced lines of credit: As a supplier can reduce the amount of credit to a customer, banks can also reduce the amount of credit available to their customers. It can be due to company-specific reasons, such as deteriorating business trends in the company or in the bank itself. In other cases, it can be a response to a customer's poor track record of debt repayment. The reductions may be mandated by governments or may be due to conditions in the credit markets, such as tighter access to funds from central banks.
- Low liquidity positions.
User Contributed Comments 3
User | Comment |
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myron | Drags are delay and slowing in cash inflows While pulls are accelerating cash outflows. Think of pull as something sucking out the cash from a corps. Link up the concept to a vacuum cleaner lol. |
zamian | Liquidity management refers to how a company balances its short-term liabilities with short-term assets. |
zamian | Drags has R in it .. receipts/receivables Pulls have L in it .. liabilities or outflows. |
I am using your study notes and I know of at least 5 other friends of mine who used it and passed the exam last Dec. Keep up your great work!
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