What is Liquidity?

We all have a sense of what liquidity is, which relates to how easily something can be sold or converted to cash. When evaluating a business loan request, we look at liquidity in a slightly different context. For the purpose of underwriting and analysis, we consider liquidity the ability to satisfy current obligations. Of course, those current obligations will need to be paid for with cash!

Consider the following example: Is $10 million in cash a lot of liquidity? We want to say “yes” because $10 million can purchase a lot of things! However, what if the same business with this cash has $20 million in bills to pay? Clearly, that $10 million in cash is not enough, and we may argue the company actually lacks adequate liquidity.

A common way we assess liquidity is by dividing “current assets” by “current liabilities” to produce a “current ratio.” Current assets are assets we expect to convert to cash within 12 months, and current liabilities are obligations which must be paid within 12 months. Ideally, we would like to see a current ratio greater than 1.00x, which indicates there are enough current assets to produce the cash needed to pay all current liabilities. In our example above, $10 million in cash divided by $20 million in bills gives a current ratio of 0.50x.

Part of the credit analysis process is determining whether current assets are truly expected to convert to cash in the short-term. For example, inventory assets do not come with a guarantee that they will be used or sold within 12 months, so they must be given special consideration. However, accounts receivable are generally paid within 30-90 days, but there may be a need to do some analysis to assess their collectability. Several different assets can be classified as current assets, and it is the analyst’s job to convey how they think any of these significant items may ultimately affect liquidity or the current ratio.

Different industries may have different standards for current ratios. Generally speaking, we like to see a current ratio of at least 1.25x. Some businesses can function with a current ratio of less than 1.00x, if they have an especially high and consistent cash flow. A good example of this is fast-food operators, who can fund most of their working capital directly from their strong predictable cash flows from month to month. But, this is only acceptable in select situations like fast-food.

The main point we need to consider when evaluating a business’s liquidity is, liquidity does not exist in a vacuum.  Even though a large amount of cash or receivables may appear to be an ample amount of resources, we have to consider what bills need to be paid too.  $10 million may be a lot of money, but when compared to $20 million in bills, it is much less significant!