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Subject 3. Measuring Liquidity PDF Download

Almost all liquidity/activity ratios are covered in Reading 18 [Understanding Balance Sheets] and Reading 20 [Financial Analysis Techniques].

Liquidity Ratios

Liquidity ratios measure the ability of a company to meet future short-term financial obligations from current assets and, more importantly, cash flows. Each of the following ratios takes a slightly different view of cash or near-cash items.

  • Current Ratio is a measure of the number of dollars of current assets available to meet current obligations. It is the best-known liquidity measure. A current ratio of less than 1 indicates the company has negative working capital.

  • Quick Ratio (Acid-Test Ratio) eliminates less liquid assets, such as inventory and pre-paid expenses, from the current ratio. If inventory is not moving, the quick ratio is a better indicator of cash and near-cash items that will be available to meet current obligations.

  • Cash Ratio is the most conservative liquidity ratio, determined by eliminating receivables from the quick ratio. As with the elimination of inventory in the quick ratio, there is no guarantee that the receivables will be collected.

Activity Ratios

A company's operating activities require investments in both short-term (inventory and accounts receivable) and long-term (property, plant, and equipment) assets. Activity ratios describe the relationship between the company's level of operations (usually defined as sales) and the assets needed to sustain operating activities. They measure how well a company manages its various assets.

  • Receivables turnover measures the liquidity of the receivables - that is, how quickly receivables are collected or turn over. The lower the turnover ratio, the more time it takes for a company to collect on a sale and the longer before a sale becomes cash.

    receivables turnover = credit sales / average receivables

    This ratio provides a better level of detail than the current or quick ratio. A company could have a favorable current or quick ratio, but if the receivables turn over very slowly, these ratios would not be a good measure of liquidity. The same applies for the inventory turnover below.

    This ratio also implies an average collection period (the number of days it takes for the company's customers to pay their bills): number of days of receivables = average accounts receivable / (sales on credit/365)

  • Inventory turnover measures how fast the company moves its inventory through the system. The lower the turnover ratio, the longer the time between when the good is produced or purchased and when it is sold.

    inventory turnover = COGS / average inventory

    An abnormally high inventory turnover and a short processing time could mean inadequate inventory, which could lead to outages, backorders, and slow delivery to customers, adversely affecting sales. An extremely low inventory turnover value implies capital is being tied up in inventory and could signal obsolete inventory.

    number of days of inventory = average inventory / (COGS/365)
  • Payables turnover measures the length of time a company has to pay its current liabilities to suppliers. This ratio examines the use of trade credit. The longer the time, the better it is for the company, since it is an interest-free loan and offsets the lack of cash from receivables and inventory turnovers

    payables turnover = purchases / average trade payables

    The following measures the number of days it takes for the company to pay its bills.

    number of days of payables = average accounts payable / (Purchases/365)

The cash conversion cycle is the time period that exists from when the company pays out money for the purchase of raw materials to when it gets the money back from the purchasers of the company's finished goods.

cash conversion cycle = days of inventory + days of receivables - days of payables

Example

Average accounts receivable: $25,400
Average inventory: $48,290
Average accounts payable: $37,510
Credit sales: $325,700
Cost of goods sold: $180,440.
Total purchases: $188,920

How many days are in the operating cycle? How many days are in the cash cycle?

1. The receivable turnover rate tells you the number of times during the year that money is loaned to customers. Credit sales / Average accounts receivable = 325,700 / 25,400 = 12.8228.

Receivables period = 365 days / 12.8228 = 28.46 days. This tells you that it takes customers an average of 28.46 days to pay for their purchases.

2. The inventory turnover rate indicates the number of times during the year that a firm replaces its inventory. COGS / Average inventory = 180,440 / 48,290 = 3.7366

Inventory period = 365 days / 3.7366 = 97.68 days. This means inventory sits on the shelf for 97.68 days before it is sold. That's ok for a furniture store but you should be highly alarmed if a fast food restaurant has a 98-day inventory period.

3. The accounts payable is matched with total purchases to compute the turnover rate because these accounts are valued based on the wholesale, or production, cost of each item.

Payables turnover = Total purchases / Average accounts payables = 188,920 / 37,510 = 5.0365
Payables period = 365 / 5.0365 = 72.47 days. On average, it takes 72.47 days to pay suppliers.

The operating cycle begins on the day inventory is purchased and ends when the money is collected from the sale of that inventory. This cycle consists of both the inventory period and the accounts receivable period. Operating cycle = 97.68 + 28.46 = 126.14 days

The cash cycle is equal to the operating cycle minus the payables period. It is the number of days for which the firm must finance its own inventory and receivables. During the cash cycle, the firm must have sufficient cash to carry its inventory and receivables.

Cash cycle = 126.14 - 72.47 = 53.67 days

In this example, the firm must pay for its inventory 53.67 days before it collects the payment from selling that inventory. Controlling the cash cycle is a high priority for financial managers.

Learning Outcome Statements

c. compare a company's liquidity position with that of a peer companies;

CFA® 2022 Level I Curriculum, , Volume 3, Reading 29

User Contributed Comments 6

User Comment
morek Good explanations. Concise and well summarized. Thank you AN.
gracecfa Agreed! These notes are saving me so much time.
JohnnyWu Great example!
CFAToad A little confusing at first with the terminology switch on "number of days" and "period". But nice and concise.
khalifa92 the cash cycle here is written cash conversion cycle in the text book which confused me big time.
juicyton What's the difference between using total purchases and COGS in the days payable calculation?
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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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