The Firm’s Level of Aggregate Liquidity Frederick C. Scherr

1. The Firm’s Level of Aggregate
Liquidity

2. • 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

3. • 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

4. • 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?

5. Traditional Measures of the Aggregate
Liquidity of the Firm
• Current Ratio
• Quick Ratio
• Accounts Receivable Turnover Ratio
• Inventory Turnover Ratio
• Creditors Turnover ratio

6. 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

7. • 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

8. 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

9. 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

10. 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

11. 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

12. • Payment Deferral Period= (All
payables/Cost of sales)*360
• Sales related payables and accruals
• The time a firm can escape from paying
the payables

13. • 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.

14. • 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

15. • Traditional measures of liquidity may not
signal when changes in liquidity has
occurred
• May give conflicting signals regarding the
direction of these changes

16. • Cash Conversion Cycle (CCC)
• Comprehensive Liquidity Index (CLI)
• Net Liquid Balance (NLB)
• The Lambda Index
Improved Indices for Measuring
Aggregate Liquidity

17. • 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

18. • 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

19. • Calculated as:
CCC = DIO+DSO-DPO
Where:
DIO represents days inventory
outstanding
DSO represents days sales outstanding
DPO represents days payable outstanding
• CCC heavily dependent upon inventory and
receivables of current assets, does not
count cash in hand or cash at bank.

20. 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

21. 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.

22. • 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

23. 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

24. • 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