Analyzing Short-Term Liquidity Risk
Short-term liquidity is the firm’s ability to satisfy payment obligations to suppliers, employees, and creditors for short-term borrowings, the current portion of long-term debt, and other short-term liabilities. Thus, the analysis of short-term liquidity risk requires an understanding of the operating cycle of a firm. Consider a typical manufacturing firm that acquires raw materials on account, promising to pay suppliers within 30–60 days. The firm then combines the raw materials, labor, and other inputs to produce a product. It pays for some of these costs at the time of incurrence and delays payment of other costs. At some point, the firm sells the product to a customer, probably on account. It then collects the customer’s account and pays suppliers and others for purchases on account
If a firm (1) can delay all cash outflows to suppliers, employees, and others until it receives cash from customers and (2) receives more cash than it must disburse, the firm will not likely encounter short-term liquidity problems. Most firms, however, cannot time their cash inflows and outflows precisely, especially firms in the start-up or growth phase. Employees may require weekly or semimonthly payments, whereas customers may delay payments for 30 days or more. Firms may experience rapid growth and need to produce more units of product than they sell during a period. Even if perfectly timed, the cash outflows to support the higher level of production in this period can exceed customers’ cash inflows this period from the lower level of sales of prior periods. Firms that operate at a net loss for a period often find that the completion of the operating cycle results in a net cash outflow instead of a net cash inflow. As an extreme example, consider a single malt Scotch whiskey distillery that incurs significant cash outflows for grains and other ingredients, distills the whiskey, and then ages it in wooden barrels for many years before finally generating cash inflows from sales to customers.
Of course, long-term leverage can trigger short-term liquidity problems. For example, a firm may assume a relatively high percentage of long-term debt in its capital structure. This level of debt usually requires periodic interest payments and may also require repayments of principal. For some firms, especially financial, real estate, and energy firms, interest expense is among the largest single costs. The operating cycle must generate sufficient cash not only to supply operating working capital needs, but also to service debt. Financially healthy firms frequently bridge temporary cash flow gaps in their operating cycles with short-term borrowing. Such firms issue commercial paper or obtain three- to six-month bank loans. Most firms maintain lines of credit with their banks to obtain cash quickly for working capital needs. Financial statement footnotes usually disclose the amount of the line of credit and the level of borrowing used on that line during the year, as well as any financial covenant restrictions imposed by the line of credit agreements.
A simple way to quickly grasp short-term liquidity issues is to examine commonsize balance sheets, . Common-size balance sheets provide a basic quantification of the relative amounts invested in various types of assets versus liabilities. For example, Exhibit 1.17 shows that PepsiCo maintains 25.1% of its assets as current relative to a slightly smaller 22.9% of assets financed throug current liabilities. We discuss six financial statement ratios for assessing short-term liquidity risk:
1. Current ratio
2. Quick ratio
3. Operating cash flow to current liabilities ratio
4. Accounts receivable turnover
5. Inventory turnover
6. Accounts payable turnover
Short-term liquidity is the firm’s ability to satisfy payment obligations to suppliers, employees, and creditors for short-term borrowings, the current portion of long-term debt, and other short-term liabilities. Thus, the analysis of short-term liquidity risk requires an understanding of the operating cycle of a firm. Consider a typical manufacturing firm that acquires raw materials on account, promising to pay suppliers within 30–60 days. The firm then combines the raw materials, labor, and other inputs to produce a product. It pays for some of these costs at the time of incurrence and delays payment of other costs. At some point, the firm sells the product to a customer, probably on account. It then collects the customer’s account and pays suppliers and others for purchases on account
If a firm (1) can delay all cash outflows to suppliers, employees, and others until it receives cash from customers and (2) receives more cash than it must disburse, the firm will not likely encounter short-term liquidity problems. Most firms, however, cannot time their cash inflows and outflows precisely, especially firms in the start-up or growth phase. Employees may require weekly or semimonthly payments, whereas customers may delay payments for 30 days or more. Firms may experience rapid growth and need to produce more units of product than they sell during a period. Even if perfectly timed, the cash outflows to support the higher level of production in this period can exceed customers’ cash inflows this period from the lower level of sales of prior periods. Firms that operate at a net loss for a period often find that the completion of the operating cycle results in a net cash outflow instead of a net cash inflow. As an extreme example, consider a single malt Scotch whiskey distillery that incurs significant cash outflows for grains and other ingredients, distills the whiskey, and then ages it in wooden barrels for many years before finally generating cash inflows from sales to customers.
Of course, long-term leverage can trigger short-term liquidity problems. For example, a firm may assume a relatively high percentage of long-term debt in its capital structure. This level of debt usually requires periodic interest payments and may also require repayments of principal. For some firms, especially financial, real estate, and energy firms, interest expense is among the largest single costs. The operating cycle must generate sufficient cash not only to supply operating working capital needs, but also to service debt. Financially healthy firms frequently bridge temporary cash flow gaps in their operating cycles with short-term borrowing. Such firms issue commercial paper or obtain three- to six-month bank loans. Most firms maintain lines of credit with their banks to obtain cash quickly for working capital needs. Financial statement footnotes usually disclose the amount of the line of credit and the level of borrowing used on that line during the year, as well as any financial covenant restrictions imposed by the line of credit agreements.
A simple way to quickly grasp short-term liquidity issues is to examine commonsize balance sheets, . Common-size balance sheets provide a basic quantification of the relative amounts invested in various types of assets versus liabilities. For example, Exhibit 1.17 shows that PepsiCo maintains 25.1% of its assets as current relative to a slightly smaller 22.9% of assets financed throug current liabilities. We discuss six financial statement ratios for assessing short-term liquidity risk:
1. Current ratio
2. Quick ratio
3. Operating cash flow to current liabilities ratio
4. Accounts receivable turnover
5. Inventory turnover
6. Accounts payable turnover
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