A Step Ahead: Analyze Liquidity like a Lender

Lending standards have tightened over the past several years in response to regulatory changes and risks in the markets. In order for organizations to gain access to the funds they need in order to grow or sustain their organizations, they must meet certain financial criteria or metrics to be considered an acceptable risk, obtain favorable terms, and secure a low interest rate. One factor banks take into consideration during the loan process is the liquidity of the potential borrower. Liquidity is simply explained as an asset’s or liability’s nearness to cash. When viewed in terms of an organization, liquidity refers to that organization’s ability to meet short term obligations with short term assets. Lenders view a company’s liquidity as a litmus test for their ability to pay back funds borrowed. Measuring your organization’s liquidity is also an important part of internal financial management. While many organizations are familiar with simple point in time measurements of liquidity such as the current ratio, acid-test ratio, debt service coverage ratio, etc., there are other methods, such as the Cash Conversion Cycle (CCC), which takes into account the timing of the cash cycle. The CCC is often used by lenders in determining an organization’s creditworthiness.

There are many static measures of liquidity a company can calculate quickly and keep track of over time. The most common liquidity measure of this type is the current ratio. The current ratio measures how many times the organization can cover current liabilities with current assets. For example, if a company has $10,000,000 of current assets (cash, receivables, inventory, etc.) and $2,500,000 in current liabilities (payables, etc.) the current ratio would be $10,000,000/$2,500,000 or 4. This means the Company could cover their current liabilities four times with their current assets. This method gives you a simple breakdown of your current liquidity at a point in time; however, it fails to incorporate a measure of time in the cash cycle.

The Cash Conversion Cycle calculation includes the element of time by determining how long it will take to convert resources into cash and how much time the organization has to pay its bills without penalty. This is a much better way of portraying true liquidity than a static ratio. The CCC is measured in days, with a shorter CCC being favorable. The CCC is calculated as:

CCC = DIO + DSO – DPO

DIO – Days inventory outstanding
DSO – Days sales outstanding
DPO – Days payables outstanding

Why is the CCC so much better? The CCC is a demonstration of your cash flow, including timing challenges. Many organizations obtain lines of credit to bridge the gap between their cash being tied up in inventory, receivables and other short term assets and meeting their short term obligations such as payables and accrued payroll. The cash conversion cycle gives lenders a way to measure management’s efficiency in managing these key areas of cash flows. It is important to note that while your CCC can improve over time based on efficiency, it is also likely to change with the economy and/or seasonally, and should be measured against organizations that would be considered peers. From an internal perspective, understanding your CCC can uncover areas for improvement. For example – If you have customers that routinely pay in 60 days, can you speed that up? Would it be possible to carry less inventory on hand without impacting delivery time to customers? If you are paying vendors immediately can you obtain vendor financing for 30 days without fees?

Organizations can stay a step ahead by frequently measuring their liquidity and using multiple methods of measurement, thus alerting them to potential problems early on. If liquidity problems are not identified quickly, they could pose cash-flow problems, make it difficult to obtain financing and possibly affect existing loans, namely those that have certain liquidity covenants in place. The better you understand your cash flows and cash needs, the more persuasive you can be when seeking financing. If you are attempting to obtain financing, then using industry benchmarks are a good way to see how you might appear as a risk compared to other organizations in your market.

If you have any questions about obtaining financing or analyzing liquidity, please contact your MKS&H representative. They will be happy to assist you.