Give the CCC a Chance

Many loan covenants include a minimum liquidity threshold based on static metrics, such as the current or quick ratio. Banks have learned the hard way that a significant decline in liquidity can foreshadow bankruptcy. But few lenders consider, or even know about, the cash conversion cycle (CCC), which factors timing into the liquidity equation.

Determining liquidity

Liquidity refers to an asset’s nearness to cash. Current assets — those that will be consumed or converted to cash within the next 12 months — determine a business’s liquidity. Marketable securities generally are more liquid than trade receivables, which are typically more liquid than inventories.

What are the most common liquidity metrics?

Static liquidity measures tell whether the company’s current assets are sufficient to cover current liabilities. For example, a loan agreement may require a borrower to maintain a current ratio of 1.75. This means that, for every $1 of current liabilities, the borrower should have at least $1.75 of current assets.

The quick (or acid-test) ratio is a more conservative static liquidity measure. It typically compares the most liquid current assets (cash, marketable securities and trade receivables) to current liabilities.

Suppose you are comparing two borrowers. Borrower A has a current ratio of 2.5 and a quick ratio of 1.8. Borrower B has a current ratio of 1.5 and a quick ratio of 1.0. Both have sufficient current assets to cover their current liabilities, but Borrower A appears to be more liquid and, thus, healthier. However, if you compute the CCC, you might come to a different conclusion.

How is the CCC different?

Current ratios assume that cash, receivables and inventories are all immediately available to pay off debt. The CCC accounts for the timing of converting current assets to cash and paying off current liabilities. It is a function of three other ratios:

CCC = Days in Inventory + Days in Receivables – Days in Payables

The CCC gauges how efficiently a borrower manages its working capital. A positive CCC indicates the number of days a company must borrow or tie up capital while awaiting payment from customers. A negative CCC represents the number of days a company has received cash from customers before it must pay its suppliers. A strong borrower will have a low or negative CCC.

Who looks better now?

Returning to the example, suppose Borrower A maintains 60 days in inventory, 80 days in receivables and 30 days in payables, which generates a CCC of 110 days. But Borrower B has 45 days in inventory, 45 days in receivables and 60 days in payables, which generates a CCC of 30 days. Suddenly, Borrower B looks more efficient.

Borrower B carries less inventory and incurs lower carrying costs. It also collects from customers faster than Company A. And it extends its payments to suppliers longer, taking advantage of a form of interest-free financing.

Based on our expanded liquidity analysis, Company B appears stronger, as long as inventories are adequate to meet customer demand, collections are without excessive early bird discounts, and suppliers aren’t angry with the two-month lead time on payables.

Evaluate other metrics

When used in conjunction with traditional static measures of liquidity, the CCC offers greater insight into a borrower’s liquidity position over time. But before making any credit decisions, evaluate other metrics — for example, profitability, leverage and growth — and compare the borrower to others in its industry.