Log in / Register
Home arrow Accounting arrow International Financial Reporting
< Prev   CONTENTS   Next >

7.2.5. Liquidity

Another effect of the combination of profitability, gearing and management of cash flows is the status of the entity's liquidity.

Liquidity represents the ability of the entity to pay for its current liabilities counting on its current assets. An entity that can honour its current liabilities (including not only trade creditors, but also interest and short term component of long term loans) by using its current assets is said to be liquid. An entity whose current assets are not sufficient to cover honour the current liabilities, but which as a consequence has to dispose of non-current assets or indeed repeatedly renew its short term loans (transforming them de facto in long term ones), is said to be illiquid.

The assessment of whether an entity is liquid or illiquid can be attempted by using a set of ratios: current and quick ratios, which compare the amount of current assets to the amount of current liabilities at a point in time, and the debtors', creditors' and inventory's days, which measure the time it takes on average for the cash flows to enter or leave the entity from the day of their economic origin.

The formulae are as follows:

Current ratio = current assets / current liabilities

Quick ratio = (current assets - inventory) / current liabilities

Debtors' days = (trade debtors / sales) x 365

Creditors' days = (trade creditors / purchases) x 365

Inventory's days = (inventory / cost of sales) x 365

These ratios are not free from inconsistencies and limitations in their use. Among others: (i) they refer to trade creditors and debtors, whilst we are interested in the whole of the cash flows, but this makes the results more reliable and meaningful; (ii) purchases are normally not given in the account, hence they must be constructed starting from cost of sales and adjusting for amortization, depreciation and variation of inventories (see cost of sales in chapter 4 on income statement); and (iii) they should refer to more representative values of the debtors, creditors and inventory than the closing ones, e.g. annual averages.

A general rule states that the current and quick ratios should be high enough to guarantee that the entity will be able to honour its current liabilities, but also low enough to prevent the entity from having capital tied up in non-productive investment, i.e. cash, debtors, inventory. However, what 'high' and 'low' mean depends on a number of factors: the entity's strategy, its business, its industry and its monetary cycle. The latter refers to the timing of the cash inflows and outflows.

By combining debtors', creditors' and inventory's days it is possible to work out the monetary cycle, i.e. how long it takes for the entity, on average, to transform a cash outflow in a cash inflow. See figure 10

a positive monetary cycle

Figure 10 - a positive monetary cycle

Although the most normal situation is that entities show a positive monetary cycle, i.e. they spend cash before receiving cash from the related activities, hence they have a cycle made of a positive number of days, it is quite frequent in certain industries that the monetary cycle is negative.20 The meaning of this is that the entity receives cash for certain activities, in advance of spending it for the same activities. This is typical of large retailer chains, which sell very quickly to customers who pay very quickly (often they pay contextually to the sale) and pay their suppliers long after having purchased from them. In this type of scenarios current and quick ratios below the value of 1, are perfectly acceptable, given that although the value of current assets at a given point is not enough to pay for the current liabilities at that given point, it is also true that those assets will be transformed in cash more quickly (hence more frequently) than those liabilities will fall due. See figure 11.

a negative monetary cycle

Figure 11 - a negative monetary cycle

Also, when performing a liquidity analysis, it is advisable, once again, that you refer to the entity's strategy, to devise what values are appropriate and justifiable. For example, an entity whose business is to provide parts and components for aircraft maintenance and whose mission statement is to respond, with a less than 24 hour delivery, to any client's request, will need to have very high inventory levels, which will make its current ratio abnormal in comparison with other entities operating in different fields.

7.3. A holistic and dynamic approach to analysis and interpretation

Although the process of analysis, by its very nature, is based on dissecting the various aspects of the entity's performance and situation, in order to enable us to consider them in specific comparison with similar aspects of other entities (individually or in aggregations), we should not overlook the fact that the entity is one. As such every aspect of its performance and situation is linked to the others, in a complex interconnection of causes and effects, which are dictated by the entity's declared strategy and the entity's contingent facts, which might have significantly departed from the planned strategy, hence the analysis and interpretation must follow a holistic approach. The implication is that any consideration about performance and situation must be supported by the evaluation of a number of different aspects. For example, when considering an entity's ROE higher than the relevant competitors, an evaluation of the Gearing must be done to assess if that higher profitability bears a higher risk. The analysis will include the calculation of the interest cover, to assess the sustainability of that level of gearing. Also, it must be assessed how sustainable that profitability is, by evaluating the underling performance as opposed to the exceptional events and whether it comes from a configuration of volume and margin (ROS and ATO) that complies with the declared strategy.

Furthermore, every aspect of the entity is affected by a continuous change and transformation, hence the analysis must be based on a dynamic perspective. For example an entity that has just embarked in a fast paced expansion process, might have a seemingly plunging ROCE, caused by the distribution and other administrative costs needed for the expansion to take place. However, if the expansion has been successful and its Gross profit percent has remained at the desired level, it is likely that those costs that affected the ROCE will not occur again, leading to a restored ROCE and, consequent to the expansion, an improved ROE, subject to checking if the expansion was conducted by raising credit capital at a cost below ROCE or equity less than proportionally to the increase of the profit.

Finally, the business sustainability must be tested, given that the entity's very existence might depend on its weakest aspect; whereby a profitable and solid entity might collapse for bad liquidity management, whilst an entity that seems to thrive might, in fact, being burning its resources and undermining its reputation on the market to an extent that endangers its medium and long existence. Also, an entity might appear strong in every aspect of its performance and situation, but is hiding a miscalculation of the risk that it has taken on board and that is not fairly reflected in its accounts... and, to point your attention on how important this effect can be, you should recall that this is one of the widely accepted causes of the current global financial crisis.

Found a mistake? Please highlight the word and press Shift + Enter  
< Prev   CONTENTS   Next >
Business & Finance
Computer Science
Language & Literature
Political science