Working Capital and Liquidity

Corporate Issuers

Liquidity

Learning Outcome Statement:

explain liquidity and compare issuers’ liquidity levels

Summary:

Liquidity refers to the ease with which an asset can be converted into cash or a liability can be settled. For an issuer, liquidity indicates its ability to meet short-term liabilities with its short-term assets. Primary liquidity sources include cash, marketable securities, borrowings, and cash flow from operations. Secondary sources, used in more dire financial situations, include actions like issuing equity or selling assets. Factors affecting liquidity include drags (delays in cash inflows) and pulls (accelerations in cash outflows). Liquidity is measured and evaluated using ratios such as the current ratio, quick ratio, and cash ratio.

Key Concepts:

Primary Liquidity Sources

Primary sources of liquidity are the most readily accessible assets a company can use to meet short-term obligations. These include cash and marketable securities, borrowings, and cash flows from business operations.

Secondary Liquidity Sources

Secondary sources of liquidity are used when primary sources are insufficient. These include actions like suspending dividends, reducing capital expenditures, issuing equity, renegotiating contracts, and selling assets.

Factors Affecting Liquidity: Drags and Pulls

Drags on liquidity are factors that delay cash inflows, such as uncollected receivables or obsolete inventory. Pulls on liquidity are factors that accelerate cash outflows or limit trade credit, such as making early payments or facing reduced credit limits.

Measuring and Evaluating Liquidity

Liquidity is measured using ratios like the current ratio (total current assets divided by total current liabilities), quick ratio (cash, marketable securities, and receivables divided by current liabilities), and cash ratio (cash and marketable securities divided by current liabilities). These ratios help assess a firm's ability to meet short-term obligations.

Formulas:

Cash Flow from Operations

Cash\,flows\,from\,operations = Cash\,received\,from\,customers + Interest\,and\,dividends\,received - Cash\,paid\,to\,employees\,and\,suppliers - Taxes\,paid - Interest\,paid

This formula calculates the net cash flow from primary business activities over a period.

Variables:

$Cash\,received\,from\,customers$ :: Cash inflows from sales or services
$Interest\,and\,dividends\,received$ :: Cash inflows from financial investments
$Cash\,paid\,to\,employees\,and\,suppliers$ :: Cash outflows for operational expenses
$Taxes\,paid$ :: Cash outflows to government entities
$Interest\,paid$ :: Cash outflows to lenders

Units: currency

Free Cash Flow

Free\,cash\,flow = Cash\,flows\,from\,operations - Investments\,in\,long-term\,assets

This formula calculates the cash available after accounting for capital investments.

Variables:

$Cash\,flows\,from\,operations$ :: Net cash flow from primary business activities
$Investments\,in\,long-term\,assets$ :: Cash outflows for capital investments

Units: currency

Current Ratio

Current\,ratio = \frac{Current\,assets}{Current\,liabilities}

This ratio measures a firm's ability to cover its short-term obligations with its short-term assets.

Variables:

$Current\,assets$ :: Total assets expected to be converted to cash within a year
$Current\,liabilities$ :: Total liabilities due within a year

Units: ratio

Quick Ratio

Quick\,ratio = \frac{Cash + Short-term\,marketable\,instruments + Receivables}{Current\,liabilities}

This ratio measures the ability to meet short-term obligations without selling inventory.

Variables:

$Cash$ :: Cash on hand
$Short-term\,marketable\,instruments$ :: Securities that can be quickly converted into cash
$Receivables$ :: Money owed to the company by its customers
$Current\,liabilities$ :: Obligations due within one year

Units: ratio

Cash Ratio

Cash\,ratio = \frac{Cash + Short-term\,marketable\,instruments}{Current\,liabilities}

This is the most conservative liquidity ratio, indicating the ability to cover short-term obligations with the most liquid assets.

Variables:

$Cash$ :: Cash on hand
$Short-term\,marketable\,instruments$ :: Securities that can be quickly converted into cash
$Current\,liabilities$ :: Obligations due within one year

Units: ratio

Managing Working Capital and Liquidity

Learning Outcome Statement:

describe issuers’ objectives and compare methods for managing working capital and liquidity

Summary:

The management of working capital and liquidity involves strategies to maximize firm value while ensuring sufficient liquidity to meet day-to-day operations and creditor obligations. This includes managing cash conversion cycles, forecasting liquidity needs, and optimizing the balance between current assets and liabilities. Different approaches (conservative, aggressive, and moderate) are used depending on the firm's business model, industry, and financial flexibility needs.

Key Concepts:

Working Capital Management

Involves estimating optimal working capital requirements based on revenue forecasts and distinguishing between permanent and variable current assets. It also includes evaluating the costs and benefits of inventory and receivables policies.

Liquidity Management

Focuses on a firm's ability to convert resources into cash to meet immediate obligations. Effective liquidity management includes maintaining diversified credit sources and ensuring competitive financing terms.

Short-Term Funding

Entails developing a strategy for when and how to borrow in the short term, considering factors like cost, flexibility, and legal or regulatory constraints. It aims to secure adequate funding capacity for variable cash needs.

Approaches to Working Capital Management

Includes conservative, moderate, and aggressive approaches, each with different levels of current assets and reliance on short-term or long-term financing, tailored to match the firm's operational needs and financial strategies.

Formulas:

Cash Ratio

\text{Cash Ratio} = \frac{\text{Cash} + \text{Marketable Securities}}{\text{Current Liabilities}}

Measures the liquidity of the company by assessing how much of the current liabilities can be paid off with the most liquid assets.

Variables:

$Cash$ :: Total cash available
$Marketable Securities$ :: Short-term investments that can be quickly converted into cash
$Current Liabilities$ :: Liabilities due within one year

Units: ratio

Quick Ratio

\text{Quick Ratio} = \frac{\text{Cash} + \text{Marketable Securities} + \text{Accounts Receivable}}{\text{Current Liabilities}}

Provides a more inclusive measure of liquidity by including accounts receivable along with cash and marketable securities against current liabilities.

Variables:

$Accounts Receivable$ :: Money owed to the company by its customers

Units: ratio

Cash Conversion Cycle

Learning Outcome Statement:

explain the cash conversion cycle and compare issuers’ cash conversion cycles

Summary:

The cash conversion cycle (CCC) measures the time span between a company's outlay of cash for raw materials and receiving payment from customers for products sold, effectively tracking the liquidity and efficiency of a company's operations. It includes three components: Days of Inventory on Hand (DOH), Days Sales Outstanding (DSO), and Days Payable Outstanding (DPO). The CCC is crucial for understanding how long a company's funds are tied up in operations and how effectively it manages its working capital.

Key Concepts:

Operating Cycle

The operating cycle is the process through which a company converts its inventory into cash. It encompasses the acquisition of raw materials, production of goods, sale of goods, and collection of receivables.

Days of Inventory on Hand (DOH)

DOH measures the average number of days a company holds inventory before selling it. It is a component of the cash conversion cycle that affects how quickly a company can convert its inventory into cash.

Days Sales Outstanding (DSO)

DSO indicates the average number of days it takes for a company to collect cash from its customers after making a sale. It is a measure of the effectiveness of a company's credit and collection policies.

Days Payable Outstanding (DPO)

DPO measures the average number of days a company takes to pay its suppliers. A longer DPO can help a company manage its cash flow more effectively by retaining cash longer.

Cash Conversion Cycle (CCC)

The CCC is calculated as DOH plus DSO minus DPO. It represents the number of days a company's cash is tied up in the production and sales process before it is converted into cash through sales to customers.

Formulas:

Cash Conversion Cycle

CCC = DOH + DSO - DPO

This formula calculates the total number of days from paying suppliers to receiving cash from customers, indicating the efficiency of a company's working capital management.

Variables:

$CCC$ :: Cash Conversion Cycle
$DOH$ :: Days of Inventory on Hand
$DSO$ :: Days Sales Outstanding
$DPO$ :: Days Payable Outstanding

Units: days

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