In part two of our Evaluating Liquidity blog, we apply the definitions and techniques discussed in part one. If you haven’t already done so, be sure to read Evaluating Liquidity - Part One, where we outline the key measures of liquidity and their underlying significance.
Liquidity is an important aspect of financial performance. In the following worked example, we analyse the trend in liquidity of a business over a two-year period.
Worked Example - Liquidity Over Time
Suppose a business observed the following trends in its liquidity ratios over the past two years:
| Metric | 2022 | 2023 |
|---|---|---|
| Working Capital Ratio | 1.5:1 | 3.5:1 |
| Quick Asset Ratio | 1:1 | 0.75:1 |
| Cash Flow Cover | 3 times | 2 times |
What judgement can we make about the business’s liquidity performance over this period? Typically, the judgement needs to be nuanced. Questions are designed such that liquidity is not unambiguously better or worse than it was previously. Typically, liquidity has improved in some respects but has worsened in others.
Such is the case in this example. The working capital ratio has increased from 1.5:1 to 3.5:1. This indicates that, for every dollar in current liabilities, the business has gone from having $1.50 in current assets in 2022 to $3.50 in current assets in 2023. This means the business is in a better position to service its current liabilities using its current assets and suggests that the business can more comfortably meet its short-term debts when they fall due.
However, the business has observed a deterioration in its quick asset ratio, which has fallen from 1:1 to 0.75:1. The fact that the quick asset ratio is now below 1:1 indicates that the business is unable to fully pay for its immediate short-term debt obligations using its liquid assets. The business will therefore have to seek out alternative sources of finance to meet these obligations, such as contributions from the owner or, in more serious circumstances, temporary external finance.
Furthermore, we observe a stark divergence between the working capital ratio, which improved, and the quick asset ratio, which deteriorated. This is significant. Given that the difference between the two ratios is the sum of inventory and prepaid expenses, this suggests that the business may be accumulating excess inventory, representing an inefficient allocation of resources.
Moreover, the business’s cash flow cover has declined from 3 times in 2022 to 2 times in 2023, indicating that net cash flows from operating activities - the primary day-to-day trading activities of the business - are now only twice the value of average current liabilities. This suggests that the business is still able to meet its short-term debts when they fall due using cash generated from its primary operations but may have difficulty doing so if the cash flow cover continues to deteriorate. Nonetheless, the fact that the cash flow cover is above 1 assures the self-sufficiency of this business - the business is able to use cash it generates from its primary function as a business to directly fund short-term debt payments.
Is the analysis different when we compare two different businesses?
A comparison of liquidity performance between two businesses at a point in time is analogous to comparing one business over two points in time. The comparative tone and techniques we employ are nearly identical. We need only modify our tone from one that describes changes over time to differences between businesses.
| Metric | Business A | Business B |
|---|---|---|
| Working Capital Ratio | 1.5:1 | 3.5:1 |
| Quick Asset Ratio | 1:1 | 0.75:1 |
| Cash Flow Cover | 3 times | 2 times |
The substance of the analysis is identical. We need only adjust our tone to compare two businesses, rather than two periods. We would make our remarks with this in mind. For instance, rather than describing a decline in the cash flow cover, we would explain that business A has a stronger cash flow cover ratio than business B.
Next time: Profitability Analysis
This concludes our two-part blog on evaluating liquidity. Be sure to check out Evaluating Liquidity - Part One. In the next blog, we will learn how to analyse the profitability of a business using key accounting ratios and profitability margins.
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FAQs
1. FAQ: How can I effectively analyse liquidity ratios and other accounting ratios?
To effectively analyse liquidity ratios (or other accounting ratios), start by understanding the formulas and significance of each ratio. Ask yourself and try to understand what the purpose is of each ratio and what it is trying to help you understand about the business.
Compare ratios over multiple periods or between different businesses to identify trends and differences. This includes understanding the context of the industry and the specific circumstances of a business. Remember that businesses in different industries may have very different accounting ratios due to particularities in that industry or business.
2. FAQ: Why is the quick asset ratio important?
The quick asset ratio is important because it measures a business's ability to meet its immediate short-term obligations using its most liquid assets. A quick asset ratio below 1:1 indicates potential liquidity issues, as the business may struggle to cover short-term debts without relying on inventory or other less liquid assets.
3. FAQ: What should a business do if its cash flow cover is declining?
If a business's cash flow cover is declining, it's crucial to investigate the underlying causes. Assess the operating activities of the business to identify any inefficiencies or changes in cash flow patterns. The business should consider implementing measures to improve cash flow, such as optimising working capital management, reducing unnecessary expenses, or exploring additional revenue streams.
