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Investing Basics: Understanding and Evaluating Liquidity

by | Last updated 27 Nov, 2022 | How to analyse stocks

When learning about the basics of investing, liquidity is one of many core concepts that are essential to know about.

It has different meanings which can cause confusion. But in the world of stocks, analysts are mostly interested in assessing firm liquidity.

A firm’s liquidity measures how capable it is to quickly transform assets on the balance sheet into cash to meet short-term obligations.

Fortunately, the standardisation of public companies’ financial reporting requires businesses to specify which of their assets or liability are current and non-current.

What are Current and Non-Current Items?

The word “current” refers to a period of time equal to one accounting period. For stocks, this is most commonly 12 months.

Therefore, Current Assets are any assets on the balance sheet that can be transformed into cash within 12 months without loss in value. These include Cash, Short Term Investments, Receivables, and Inventory.

Similarly, a Current Liability is any liability on the balance sheet that must be paid within 12 months. These include Accounts Payable, Short-Term Debt, and Leases.

Non-Current Assets are any asset on the balance sheet that cannot be transformed into cash within twelve months without loss in value. These include Properties (such as factories or offices), Equipment, Long Term Investments, and Intangible Assets.

Non-Current Liabilities are any liability on the balance sheet that do not need to be paid within twelve months. These include Long-Term Debt, Debt Interest, and Deferred Income Taxes.

Investing Basics: Evaluating Liquidity

Two financial ratios are most commonly used to evaluate firm liquidity.

The first is the Current Ratio.

Current Ratio =\frac{Current Assets}{Current Liabilities}

It simply compares the total number of current assets against the total number of current liabilities. Any value greater than 1.0 means that the stock has enough liquid assets to meet it’s short term obligations.

A value of less than 1.0 indicates the firm does not have enough liquidity to meet its short-term obligations. Therefore it will have to find a way to raise capital.

The second is the Quick Ratio.

Quick Ratio = \frac{Current Assets - Inventory}{Current Liabilities}

This ratio works in the same way as the Current Ratio. Except, the value of inventory is ignored, making it more strict.

Suppose a business is in sudden need of cash and decides to liquidate its inventory in a matter of weeks. In that case, it is unlikely that it will receive full value. Therefore relying on inventory as a source of liquidity can be dangerous. The Quick Ratio can easily spot when this is happening.

Which Ratio should you use?

It depends on the situation. The Quick Ratio can often be too strict when evaluating a business’s liquidity.

However, if inventory represents a large portion of total current assets, then the Quick Ratio may be more appropriate.

Suppose there is a large difference between the Current Ratio and Quick Ratio. In that case, it may also indicate that the business cannot sell its inventory, leading to a build-up of assets that may never be transformed into cash.

This comparison alone is insufficient to make a conclusion. But a large difference suggests that further investigation is required.

Going even deeper than the investing basics

The Current and Quick Ratios are easy to calculate and a good indication of the level of liquidity within a firm. But there is more information an analyst can uncover.

Investing basics state that the Current Ratio should ideally have a value greater than 1.0, and the bigger the number, the better. Or is it? While a firm with a large Current Ratio does indicate strong liquidity, it begs why it is holding onto so much cash equivalents. Don’t forget, cash equivalents doesn’t create value unless invested in projects that yield returns in the future.

Receivables is another figure to keep an eye on. Receivables represent revenue that has yet to be received for products/services that have already been delivered to the customer. Sometimes people don’t pay their bills and receivables don’t get collected. 

Each year, a business will write-off receivables that it doesn’t believe will ever be collected. The amount of which can be found within the Notes section of the annual report. Taking this data from multiple reports will show a trend as to whether the amount being written off increases, decreasing or remaining stable.

The average can also create a forecast as to how much receivables will be written off next year. This can be used to adjust existing values before calculating the Current or Quick Ratio, giving a more accurate picture of firm liquidity.

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