Liquidity sources and liquidity ratios

What is liquidity, and where does it come from?

Liquidity is a company’s ability to meet its short-term obligations. For one asset or liability, it means how close it is to cash or settlement: cash is already cash, receivables take weeks to collect, inventory takes longer, and a payable due in five days is more pressing than a lease payment due next month. A company’s overall liquidity depends on the amounts and the liquidity of its short-term assets and liabilities, which follow from its business model and its cash conversion cycle.

The company has two tiers of sources to call on.

Sources of liquidityways to find cash for short-term obligations

• Primary sources Memorize normal course, no damage to operations
  • Cash and marketable securities Memorize on hand, sold quickly at little loss
  • Borrowing Memorize bank lines, bonds, suppliers trade credit
  • Cash flow from the business Memorize the main long-run source
• Secondary sources Memorize stress, costly, often a warning sign
  • Suspend dividends, delay capital spending Memorize preserve cash now
  • Issue equity Memorize dilutes existing owners
  • Renegotiate contracts Memorize debt, leases, customer and supplier terms
  • Sell assets Memorize liquidation costs apply
  • Bankruptcy protection Memorize reorganize and keep operating

Primary liquidity sources are the cash the company can reach in the normal course without hurting operations:

• Cash and marketable securities on hand, which can be used or sold quickly with little loss.
• Borrowing from banks, bondholders or suppliers (trade credit). It helps now but creates a debt to repay.
• Cash flow from the business. It takes time to arrive, but for a profitable company it is the main long-run source. A firm with a supplier bill of 25 due in three months that expects 70 of operating cash over those months needs neither its cash balance nor new loans to pay it.

Secondary liquidity sources are used when the primary sources are not enough. They cost more and often signal a deteriorating position: suspending or cutting dividends, delaying or cutting capital spending (which can damage long-term value), issuing equity (dilution), renegotiating contracts (refinancing short-term debt into long-term, seeking concessions on interest, rent or lease payments, or changing terms with customers and suppliers), selling assets, and filing for bankruptcy protection to reorganize.

Exam tip Ask “is this part of normal business or an emergency step?” Normal means primary. Emergency means secondary.

How is cash flow from the business measured?

Cash flow from operations (CFO) is the cash profit of the main business activities:

$$\text{CFO} = \text{Cash from customers} + \text{Interest and dividends received} - \text{Cash paid to employees and suppliers} - \text{Taxes paid} - \text{Interest paid}$$

CFO does not allow for the investments the company must make to keep operating or to grow. Free cash flow (FCF) does.

$$\text{FCF} = \text{CFO} - \text{Investment in long-term assets}$$

A variant of free cash flow adds back the interest paid, to measure the cash available to lenders and shareholders together. It returns later in the curriculum.

What does it cost to raise cash in a crunch?

Selling an asset quickly rarely yields full value. Liquidation costs are the fees, commissions and price discount that come with a quick sale. Net proceeds are the fair value less those costs, summed over everything sold.

$$\text{Net proceeds} = \sum_i \text{FV}_i \times (1 - c_i)$$

Go deeper Why a profitable company can still run out of cash

Profit counts sales when they are made, but cash arrives when customers pay. A fast-growing company can report rising profit while receivables and inventory swallow every unit of cash it earns. If payables fall due before customers pay, the company has to borrow, and if banks and suppliers pull their credit at that moment, it fails despite being profitable. This is why analysts study the cash conversion cycle and the liquidity ratios together with profit.

When a stressed company announces a convertible bond, a rights issue or deferred capital spending, it is drawing on secondary sources. That is a signal worth noticing.

What are drags and pulls on liquidity?

A company’s cash conversion cycle has a large effect on its liquidity position. Two forces work against it.

Pressure on liquiditytwo ways cash falls short

• Drag Memorize cash inflows come in slower
  • Uncollected receivables long days sales outstanding (DSO), delinquencies
  • Obsolete inventory unsold or sold at a discount
  • Borrowing constraints tight credit conditions
• Pull Memorize cash outflows speed up or credit shrinks
  • Paying early with no benefit funds used sooner
  • Reduced supplier credit limits after late payments
  • Limits on credit lines bank cuts
  • Chronically low liquidity often with an aggressive approach

A drag on liquidity is a lag in cash inflows. The longer receipts stay outstanding, the greater the chance they never arrive. Stale inventory ties cash up or can be sold only at a discount, and tight credit makes new short-term debt dearer or unavailable. Stricter credit and collection practices reduce drags, but they may also cut sales.

A pull on liquidity is a speeding-up of cash outflows, or a limit on trade credit that forces the company to pay out before it has received cash from sales. Typical pulls are paying early when there is no financial benefit, suppliers cutting credit limits (often after late payments), banks limiting short-term lines, and chronically low liquidity, which an aggressive working capital approach can make worse.

Some examples show how to classify.

Event	Effect
Customers start paying 10 days later	Drag
Unsold stock goes out of fashion	Drag
Lenders tighten credit conditions	Drag (and a pull if a line is cut)
Supplier cuts the credit limit	Pull
Company pays invoices ahead of the due date, no discount	Pull
A bank raises the credit limit	Neither: it adds liquidity
Credit extended to weaker customers	Drag (slower, less certain collection)

How do the liquidity ratios work?

Ratios compare firms of different sizes. They all divide by current liabilities, and each uses fewer assets on top than the last.

The current ratio is the broadest:

$$\text{Current ratio} = \frac{\text{Current assets}}{\text{Current liabilities}}$$

A positive total working capital means a current ratio above 1. The quick ratio drops inventory and other less liquid items (such as prepaid expenses):

$$\text{Quick ratio} = \frac{\text{Cash} + \text{Marketable securities} + \text{Receivables}}{\text{Current liabilities}}$$

A quick ratio above 1 means the firm could meet its short-term obligations without selling inventory, provided every receivable is collected on time. The cash ratio is the most conservative:

$$\text{Cash ratio} = \frac{\text{Cash} + \text{Marketable securities}}{\text{Current liabilities}}$$

Current liabilitiesthe denominator of all three

• Current ratio Memorize broadest: all current assets
  • Quick ratio Memorize drops inventory and prepaid items
    • Cash ratio Memorize cash and securities only: strictest

Read the ratios together, because actions can move them in different directions. If Halden spends EUR 30 million of cash on extra stock, current assets stay at 210, so the current ratio stays 1.91, but the quick ratio falls to 100 ÷ 110 = 0.91 and the cash ratio to 20 ÷ 110 = 0.18. The firm looks the same on the broadest test and much weaker on the strict ones.

Liquidity ratios are used with the activity ratios from the first lesson. The comparison with peers and over time matters more than a single value, because a normal level differs by industry.