How to Measure Liquidity Using the Cash Conversion Cycle
February 12, 2017
Gauging liquidity — how quickly assets can be converted into cash — helps bankers anticipate whether a borrower will be able to make timely loan payments. To measure liquidity, bankers traditionally look to the balance sheet and compute the current or quick ratio. But there’s also another, lesser-known metric called the cash conversion cycle (CCC).
Spotlight on liquidity metrics
Current assets — those that will be consumed or converted to cash within the next 12 months — determine a business’s liquidity. There’s generally a hierarchy of liquidity. For example, marketable securities generally are more liquid than trade receivables, which are typically more liquid than inventories.
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. Company 1 has a current ratio of 2.5 and a quick ratio of 1.8. Company 2 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 Company 1 appears to be more liquid and, thus, healthier. However, if you compute the CCC, you might come to a different conclusion.
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’s 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.
Returning to the example, suppose Company 1 maintains 60 days in inventory, 80 days in receivables and 30 days in payables, which generates a CCC of 110 days. But Company 2 has 45 days in inventory, 45 days in receivables and 60 days in payables, which generates a CCC of 30 days. Suddenly, Company 2 looks more efficient.
Company 2 carries a lower amount of inventory and incurs lower carrying costs. It also collects from customers faster than Company 1. And it extends its payments to suppliers longer, taking advantage of a form of interest-free financing.
Based on our expanded liquidity analysis, Company 2 appears stronger, as long as inventories are adequate to meet customer demand, collections are without excessive early bird discounts, and suppliers aren’t angry about the two-month lead time on payables.
A comprehensive approach
Liquidity metrics tell only part of the story and should never be used as the sole method of evaluating a borrower’s performance. Using the CCC and other liquidity benchmarks together with other tools, such as leverage, growth and profitability metrics, can help you gain a comprehensive risk assessment. It’s important to use all possible tools to ensure your credit decisions are smart ones.
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