Lecture 3 Summary (1)
LO. Describe sources of primary and secondary liquidity and factors affecting a company’s
liquidity position.
Liquidity is the extent to which a company is able to meet its short-term obligations using cash flows
and those assets that can be readily transformed into cash.
Liquidity management refers to the company’s ability to generate cash when needed, at the lowest
possible cost.
Two sources of liquidity for a company are:
Primary sources of liquidity, such as free cash flow, ready cash balances, short-term funds, cash
management.
Secondary sources of liquidity, such as negotiating debt contracts, liquidating assets, filing for
bankruptcy protection.
Lecture 3 Summary (2)
The main difference between the two is that using primary sources has no effect on the operations of a
company while using secondary sources may negatively impact a company’s financial position.
A company’s liquidity position is affected by cash receipts and the amount of cash it has to pay.
Drags on liquidity reduce cash inflows. For example, uncollected receivables, obsolete inventory, tight
credit etc.
Pulls on liquidity accelerate cash outflows. For example, earlier payment of vendor dues, reduced credit
limits (by suppliers), limits on short-term lines of credit (by banks) etc.
Lecture 3 Summary (3)
LO. Compare a company’s liquidity position with that of peers.
Financial ratios can be used to assess a company’s liquidity as well as its management of assets over
time. The commonly used ratios are:
Liquidity Ratios
Ratio Formula Interpretation
Current ratio Current assets ÷ Current liabilities The greater the current ratio the higher the
company’s liquidity
Quick ratio (Cash + Marketable securities + The higher the quick ratio the higher the
Receivables) ÷ Current liabilities company’s liquidity
Cash ratio (Cash + Marketable securities) ÷ Current The higher the cash ratio the higher the
liabilities company’s liquidity
Lecture 3 Summary (4)
Activity Ratios
Receivable Credit Sales ÷ Average receivables It is a measure of how many times, on
turnover average, accounts receivable are created by
credit sales and collected on during the fiscal
period.
Number of days 365 or days in period ÷ Receivable turnover It tells the number of days on average the
of receivables company takes to collect on the credit
accounts
Inventory Cost of goods sold ÷ Average inventory It is a measure of how many times, on
turnover average, inventory is created or acquired and
sold during the fiscal period
Lecture 3 Summary (5)
Activity Ratios
Number of days 365 or days in the period ÷ Inventory It is the length of time, on average, that the
of inventory turnover inventory remains within the company
Payables Average day’s purchases ÷ Average trade It is a measure of how long it takes the
turnover payables company to pay its own suppliers
Number of days 365 or days in the period ÷ Payables It tells the number of days on average the
of payables turnover company takes to make payments to its
suppliers.
Cash Days of inventory + Days of receivables – It measures the time from paying suppliers
conversion Days of payables for raw materials to collecting cash from
cycle customers. The shorter the cycle, the better is
the cash-generating ability of a company
