Author: Robert Wood, CPA, Principal
Guidance on Factoring Timing into the Liquidity Equation
As you know, many loan covenants include a minimum liquidity threshold based on static metrics, such as the quick ratio or current ratio. Asset based lenders have learned the hard way that a large decline in liquidity can foreshadow bankruptcy. But few banks consider (or even know about) the cash conversion cycle (CCC), which factors timing into the liquidity equation.
The term “liquidity” refers to an asset’s nearness to cash. For instance, current assets (those that will be consumed or converted to cash within the next 12 months) determine a company’s liquidity. Marketable securities are generally more liquid than trade receivables, which in turn are typically more liquid than inventories.
Common liquidity metrics
Static liquidity measures tell whether a company’s current assets are sufficient to cover its current liabilities. A loan agreement, for example, may require a borrower to maintain a current ratio of 1.75. What this means is that, for every $1 of current liabilities, the client should have at least $1.75 of current assets.
The quick ratio (also known as the acid-test) is a more conservative static liquidity measure. It compares the most liquid current assets, such as cash, trade receivables and marketable securities, to current liabilities.
Pretend you’re comparing two borrowers. Borrower A has a current ratio of 2.5 and a quick ratio of 1.8. Borrower B, on the other hand, has a current ratio of 1.5 and a quick ratio of 1.0. Both borrowers have sufficient current assets to cover their current liabilities, but Borrower A seems to be more liquid and, thus, healthier. But, if you compute the CCC, you may very well come to a different conclusion.
The CCC difference
Current ratios assume that cash, inventories and receivables are all immediately available to pay off any debt. The CCC accounts for the timing of converting all current assets to cash and then paying off current liabilities. It’s really a function of three other ratios: CCC = Days in Inventory + Days in Receivables - Days in Payables.
As you can see, the CCC gauges how efficiently a client manages working capital. A positive CCC shows the number of days a company must borrow or tie up capital while waiting for payment from customers. A negative CCC, however, represents the number of days a business has received cash from customers before it has to pay its suppliers. A strong borrower will have a low or even negative CCC.
Who is more efficient now?
If we return to the example, let’s suppose that Borrower A maintains 60 days in inventory, 80 days in receivables and 30 days in payables, which generates a CCC of 110 days. But, let’s suppose Borrower B has 45 days in inventory, 45 days in receivables and 60 days in payables, which generates a CCC of 30 days. All of a sudden, Borrower B looks a lot more efficient. Why?
Borrower B is carrying less inventory and incurring lower carrying costs. It also collects from customers much faster than Company A is. Plus, it extends its payments to suppliers longer, therefore taking advantage of a form of interest-free financing.
So, based on our expanded liquidity analysis, Company B looks a lot stronger, so long as its inventories can meet customer demand, suppliers aren’t angry with the two-month lead time on payables, and collections are without excessive early bird discounts.
The bottom line
The CCC offers greater insight into a borrower’s liquidity position over time when used in conjunction with traditional static measures of liquidity. But before you make any credit decisions, make sure you evaluate other metrics, such as profitability, leverage and growth, and then compare the borrower to others in its industry.
Freed Maxick’s Asset Based Lending Team works with dozens of asset based lenders across the country. We can assist you in evaluating the integrity of your loan portfolio using CCC and other types of analyses.For more information about our business advisory, audit, and other accounting services contact us here, or call me at 716-847-2651.