Liquidity position of a company will tell you whether the organization has staying power in tough times. Analyzing company’s liquidity position involves examining the relationship of current assets and current liabilities and in short run, how well a company can manage and fulfill its short-term obligations.
In absence of adequate cash flow to the business, company may go bankrupt and lenders will not be interested in lending money to the company.
Here are two most important reasons why you should assess company’s liquidity position before investing your hard earned money in it:
- to know the ability of a firm to meet short term obligations, and
- to know how far the company can survive in case of a disruption in the cycle such as delays in customer payments, labor strike and economic turbulence.
In this article, we will be discussing three financial tools that you can use to assess company’s liquidity position.
Working capital assessment to know liquidity position
Working capital represents the amount of current asset needed to satisfy short-term obligations or debt. Working capital analysis will tell you how the company is prepared to meet its short term obligations or immediate financial situation. Its a measure to assess short-term liquidity of a company.
If a company has enough cash or can easily access cash needed to pay its short term bills, then its liquidity position is good.
Working capital can be calculated by taking out current liabilities (CL) from current assets (CA). The formula to find out working capital of a company is:
Working capital = Current Assets – Current Liabilities
If the difference is positive, then as a fundamental analyst you gets a comfort that the liquidity position is good.
If the company doesn’t have potential to pay its bill and salary, then it may be very difficult to survive in short term.
You can also assess company’s liquidity position by calculating company’s current ratio and compare it with earlier years.
Current ratio is calculated to assess the liquidity position by comparing current assets (CA) with current liabilities (CL). It’s a good measure to know whether a company will be able to raise enough cash to pay its bills due in a year.
Current ratio = Current Assets / Current Liabilities
If the resulting figure is positive, then company is in a good position to pay its short-term obligations within the year by using its current assets. Current ratio of more than 1 indicates better liquidity of the company.
Acid test ratio – Measure liquidity of current assets
In current assets, we have certain items which can not be transformed into cash within a year. For this reason, an alternative to current ratio is the quick or acid-test ratio.
Assets that can get converted into cash within a short period of time is referred to as liquid assets. You can find company’s liquid assets under the head current assets.
To calculate quick or acid-test ratio, you need to exclude inventory from current assets before dividing it with current liabilities. Inventory is excluded because its considered as the least liquid asset. Hence:
Quick ratio = (Current Assets – inventory) / Current Liabilities
You should also look at future capacity of the company to generate revenue. If any event or due to future prospects, company’s liquidity position will change in future, then you can take a investing call.
The industry average of 2.1 is considered as good.
Low debt and high cash
While considering companies that can survive in tough times, you must look for a balance sheet that has little or no debt. In this regard, interest coverage ratio can be a great help. High interest coverage ratio indicates that the company will have difficulty in handling tough times.
Another financial toll to analyze company’s debt is debt to equity ratio.
Please note, just because a company has no debt,it doesn’t mean that you should buy the stock. You can not base your investment decisions based on one single factor or toll. In addition to company’s liquidity position, you are also required to look into so many other factors such as PEG, Price to earnings (P/E), price-to-book and Return On Equity (ROE).
Cash per share
Another best way to measure company’s liquidity position is to compare its stock price to the amount of cash per share. This ratio will be helpful when company’s stock is beaten up badly but company has enough cash in the bank. To calculate cash per share, you need to follow below steps:
- Step1: From company’s balance sheet, obtain total cash and cash equivalents.
- Step 2: Find out number of shares outstanding.
- Step 3: Divide step 1 by step 2 to get cash per share
Cash flow to net income ratio
To compare cash from from operation with the accrual basis results of operation, cash flow to net income ratio is calculated.
Formula to calculate:
Cash flow to net income ratio = cash from operations / net income
If cash flow to net income ratio is greater than 1, it is most likely due to non cash expenses. A high ratio indicates that the company’s non-cash expenses is impacting net income.
You are also required to look into the debt position of the company. If company has high debt then lenders have first rights over the cash and cash equivalents before shareholders.
Solvency ratio measures company’s ability to pay its debts and determines whether its a going concern in long-run. Liquidity ratio determine whether the company can fulfill its obligations for short term liabilities.