How To Analyse Liquidity

Published in Investing on 15 October 2009

To keep afloat, a company must meet its short-term liabilities.

Debt is big news these days, and a good few companies are having trouble with liquidity. So whenever a company announces its results, we really should have a close look at its debt situation. It isn't always immediately obvious whether a particular level of debt is especially bad, and it doesn't really matter very much if a company owes a lot as long as it is making sufficient profits from the borrowed money. In fact, financing a company's operations through debt can be a very profitable strategy.

So how can we tell if a company might be facing liquidity problems?

Today we'll take a look at three measures that can help us find out -- Interest Cover, the Current Ratio, and the Quick Ratio. Some paid-for data services will give you these ready-made, but we'll do it the cheap way and look at some accounts to see how to calculate them.

I'll use Indigo Vision (LSE: IND) and its 2009 annual report, which you can get from the company web site -- I like this report, because it is very simply and clearly presented.

Interest Cover

If a company can't meet its interest payments, it's in serious trouble, because banks and other lenders have a tendency to foreclose if nothing is done about it pretty quickly. Interest Cover is a measure of how easily a company's earnings are covering its interest payments.

It's defined quite simply, and we calculate it by dividing a company's earnings before interest and tax (EBIT) figure for an accounting period, by the interest paid in the same period.

It is generally considered that an interest cover of at least 2 is a good idea, but if earnings are volatile, we should probably look for something higher to avoid a squeeze in a low year. The tricky thing is that EBIT isn't usually stated in a company's accounts, so we have to work it out.

If we look at Indigo Vision's Income Statement on page 12 (printed page 12, PDF page 14), what we need to do is take the "Profit before tax" figure, of £3,263,000 (which has already had interest deducted) and add back the interest paid to obtain the EBIT figure. We can see that financial expenses came to a lowly £1,000, and note 5 tells us that that was all interest. So, working in thousands…

Interest Cover = (3,263 + 1) / 1 = 3,264.

Indigo Vision could have paid its interest 3,264 times over, and obviously there is no problem there.

Current Ratio

For our next measure, we need to turn to the balance sheet, on page 14. Remember that current assets comprise cash itself and assets that are expected to be turned into cash (or equivalents) within the next 12 months, and that current liabilities are payments that will become due within the next 12 months.

A good measure of short-term liquidity, then, is to compare the two, and the Current Ratio does just that, by dividing total current assets by total current liabilities. For Indigo Vision we get…

Current Ratio = 12,602 / 3,215 = 3.9

That means that Indigo Vision should be able to meet all of its next 12 months of liabilities nearly 4 times over from cash expected during the period, so it looks like there is going to be no problem meeting its obligations over the next year.

Quick Ratio

But what if a company was called upon to settle all its current liabilities with very short notice? Would it have the assets to do it? That's the question that the Quick Ratio (which is sometimes referred to as the "Acid Test") seeks to answer.

What we need to do is decide how much if its current assets a company could quickly convert to cash, and the usual way to do that is to take the total current assets figure and subtract inventories. Cash equivalents, which include things like liquid investments such as shares, can be converted quickly, and accounts receivable -- money owed for goods and services already supplied -- are usually settled within not many weeks. But inventories are goods that have already been produced but not yet sold, and so they can't be counted.

Calculating from Indigo Vision's balance sheet…

Quick Ratio = (12,602 – 2,909) / 3,215 = 3.0

So Indigo Vision could meet all of its 12-month liabilities almost immediately, without selling another thing.

So that's good then

Clearly, Indigo Vision is a company with no debt or liquidity problems whatsoever, which many would see as an enviable position to be in.

But what about other companies? If you have any favourites of your own, why not get hold of a copy of the latest annual report, have a go at working out these measures for yourself, and then posting your results as a comment below?

And if you have any problems or need any help, just point me at the report and I'll have a go at it myself.

More Investing Basics from Alan Oscroft:

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

guykguard 17 Oct 2009 , 9:07am

Nothing quite like an extreme example to make a controversial point! And a curious casualty of the credit crunch seems to be credit itself, not just the debtors. The very mention of debt these days can cause otherwise level-headed commentators to go all wobbly.

Shareholder value is mainly created by wise asset allocation and skilful operating efficiency. Financing decisions are a second order effect.

Without relevant comparisons, financial ratios are hardly helpful. While a current ratio of 2 used to be a rough-and-ready rule-of-thumb, that's all it ever was. Compared over time, the ratios may help to detect what may otherwise be more obscure. Industry comparisons may enable analysts to draw up a revealing beauty contest.

To shareholders, gearing or what used to be called 'trading on the equity' due to the tax shield of debt interest can be very advantageous. While IND's no debt policy seems to be wise, its shareholders are foregoing the tax benefits of any debt as well as some further opportunities for growth and efficiency. If other firms in the same industry are able and willing to use debt to increase their capital expenditure programme, IND's future growth rate, market share and operating margins may decline.

The risks of financial distress due to debt are real, especially when operating profits decline or a firm faces heavy legacy costs. But to imply that only debt-free firms are good and any sensibly geared ones bad is to miss a fundamental aspect of prudent business and financial management.

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