The Firm’s Level of Aggregate Liquidity

• Liquidity is the firm’s ability to quickly generate cash versus the firm’s need for cash on short notice.

• Total current assets produce cash inflows• Total current liabilities require cash

outflows• The overall relationship between current

assets and current liabilities determine the size of the total assets.

Aggregate Liquidity

• The chance of a cash stock out is lessened if current assets can provide much more cash than is needed for current liabilities.

• A firm’s aggregate liquidity position is determined by the firm’s potential cash needs and potentially available cash flows.

• Indicates a firm’s short-term debt paying capacity

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

• Development of financial strategies depend upon the application of accurate measures of aggregate liquidity.

• An important determinant of the probability of default.

Why measure and manage aggregate liquidity?

Traditional Measures of the Aggregate Liquidity of the Firm

• Current Ratio• Quick Ratio• Accounts Receivable Turnover Ratio• Inventory Turnover Ratio• Creditors Turnover ratio

Current Ratio

• Ratio of current assets to current liabilities

• Any asset or debt expected to mature in less than a year is liquid.

• Companies that have a high Current ratio figure tend to have a high cash flow

• The ratio of current assets to current liabilities, the higher the ratio the more liquid the firm is said to be

• Any asset or debt expected to mature in less than a year is liquid or current

• Mixes assets and liabilities that are in reality quite different in terms of their maturity

Current Ratio

Quick/Acid Test Ratio• (Total Current Assets-Inventories)/Total

Current Liabilities• Compares short-term cash generating

abilities with short-term cash needs by excluding inventories

• As sale of inventory is considered to be uncertain, so its encashment and liquidity

Accounts Receivable Turnover• Sales/Accounts Receivable, the number of

times we make cash from receivables• 360/Accounts Receivable Turnover =

Average Collection Period, the weighted average time that a receivable is outstanding

• The higher the turnover, the quicker a receivable turned into cash, the more liquid the firm is said to be

Inventory Turnover Ratio• Cost of goods sold/Inventory, the number

of times inventory is stocked in• 360/Inventory Turnover Ratio = Inventory

Conversion Period• The higher the turnover ratio, the more

liquid the asset is said to be• Inventory Conversion Period is the

weighted average time, a dollar is tied up in inventory

Creditors Turnover Ratio• A short-term liquidity measure used to quantify

the rate at which a company pays off its suppliers. • How many times per period the company pays its

average payable amount.• Purchases/Trade Creditors• Days Payable Outstanding= (Trade

Creditors/Purchases)* 360• Days Payable Outstanding is the weighted

average time, a dollar is financed by payables

• Payment Deferral Period= (All payables/Cost of sales)*360

• Sales related payables and accruals• The time a firm can escape from paying

the payables

• If a firm has less cash and more accounts receivable, it’s overall liquidity is reduced, but the firm’s current, quick and inventory turnover ratio would remain unchanged.

• So, no single ratio can portrait an actual picture of the firm’s financial position.

• If a firm’s inventory level drops with no increase in total inventory cost, it would reduce accounts payable, it will result in-

–Current ratio decrease, indicate decline in liquidity

–Quick ratio increase, indicate increase in liquidity

–Accounts receivable turnover unchanged, indicate unchanged liquidity

–Inventory turnover ratio increase, indicate increase in liquidity

• Traditional measures of liquidity may not signal when changes in liquidity has occurred

• May give conflicting signals regarding the direction of these changes

• Cash Conversion Cycle (CCC)• Comprehensive Liquidity Index (CLI)• Net Liquid Balance (NLB)• The Lambda Index

Improved Indices for Measuring Aggregate Liquidity

• Developed by Richards and Laughlin• Net time interval between the expenditures

of cash in paying the liabilities and the receipt of cash from the collection of receivables

• A metric that expresses the length of time, in days, that it takes for a company to convert resource inputs into cash flows.

Cash Conversion Cycle

• This metric looks at the amount of time needed to sell inventory, the amount of time needed to collect receivables and the length of time the company is afforded to pay its bills without incurring penalties.

• Does not capture the effect of current assets and current liabilities

• Calculated as:CCC = DIO+DSO-DPO

Where:DIO represents days inventory outstandingDSO represents days sales outstandingDPO represents days payable outstanding

• CCC heavily dependent upon inventory and receivables of current assets, does not count cash in hand or cash at bank.

Comprehensive Liquidity Index (CLI)

• The number of days it would take to convert accounts receivable and inventory into cash

• Determine the firm’s ability to generate sufficient cash to meet liabilities

CLI = Adjusted Assets/ Adjusted Liabilities

Net Liquid Balance

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

• NLB does not vies the firm’s investments in accounts receivable and inventory as contribution to aggregate liquidity, but considers those as additional assets to be financed.

• The accounts payable and accruals are treated as maturing obligations but as part of the firm’s permanent financing packages.

• Only “notes payable” is treated as obligation.

NLB = (Cash + Marketable Securities – Notes Payable)/Total Assets

The Lambda Index

• Measures the firm’s available credit line as part of the firm’s package of liquid reserves

• Uses a measure of uncertainty to evaluate the firm’s potential need for liquidity

• Only measure incorporating the firm’s expected cash flows in addition to its cash and near-cash stocks of assets

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

• The Lambda index uses this 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

Lambda = [Initial Reserve + E(NCF)]/Uncertainty