Assessment of liquidity - Dynamic Current Ratio Vs. Conventional Liquidity Ratio

Introduction

In this article I would like to advocate the use of a new ratio, the "dynamic current ratio", to assess a company's liquidity status instead of the static but commonly used current ratio. Brief explanation on the weaknesses of the current ratio and its two related ratios called the "quick" or "acid ratio" and the "cash ratio" will follow. These three ratios are often calculated as a group to provide the analyst with a more complete picture of the short-term liquidity status of the company being analyzed (i.e. more complete than using only one of these ratios). Description of the dynamic current ratio and the advantages of this ratio in comparison with any combination of the three aforementioned static ratios will also be presented in later part.

Current Ratio

Current ratio = Current assets / Current liabilities Inventory + Accounts receivable + Cash equivalents + Cash Accruals + Accounts payable + Notes payable

The drawback of the current ratio is that we do not know how liquid inventory and accounts receivable really are. This means that a company with a very large part of its current assets tied up as inventory could show a relatively high current ratio but still exhibit a rather low level of liquidity.

Quick Ratio



As we can see, the quick ratio does not contain any inventory. Accounts receivable are included but still without any indication as to how easily these receivables can be turned into cash.

Cash Ratio



Since the cash ratio measures only the most liquid of all assets against current liabilities, it is seen as the most conservative of the three mentioned liquidity ratios. As it is generally accepted in the accounting literature to maintain a high degree of prudence in both the preparation and analysis of financial statements, the cash ratio may not seem such a bad idea. However, I would like to argue that it is a bad idea, since it lacks accuracy. How so? The essential factor of inventory and accounts receivable converting to cash is missing.

The cash ratio does not provide a true and fair picture of a company's short-term liquidity. No ratio does and no ratio in isolation will ever be able to do this. Nevertheless, I believe that the dynamic current ratio provides the analyst with a more accurate and complete way of assessing the short-term liquidity than any of the aforementioned ratios.

Dynamic Current Ratio

One way of measuring the liquidity of inventory is to use the inventory turnover ratio to calculate the approximate number of times that inventory turns over per year. One could say that the more times inventory turns over, the more often you exchange inventory for cash and as such the more liquid it is. The same applies to accounts receivable when calculating the accounts receivable turnover ratio. That is, the more often accounts receivable turns over, the more often you exchange accounts receivable for cash and the more you extend its nearness to cash, i.e. its level of liquidity. Both ratios are shown below:



The opposite of an accounts receivable transaction is known as an accounts payable transaction, i.e. whatever is "paid" by the debtor is "cashed" by the creditor. Since a rising accounts receivable turnover ratio points to increasing liquidity, it becomes clear that a rising accounts payable turnover ratio can only indicate a decreasing liquidity. In other words, the more often you pay your bills, the less money you can keep and therefore the less liquid you will be. The accounts payable turnover ratio is shown below:



The dynamic current ratio is based on a combination of the current ratio and the three turnover ratios mentioned above, resulting in a liquidity ratio that takes into account the company's respective liquidity with regard to inventory, accounts receivable and accounts payable. In today's world of credit sales, generally the minimum time a company has to settle its bills without adversely affecting its credit relationships is 30 days. This means that there are at least 12 "risk-free" credit cycles per year. The more management extends its credit cycle, the more it risks defaulting on its payments. Based on this, one can argue that an inventory turnover ratio of six, meaning that the inventory is exchanged for cash six times per year, represents a 50% liquidity, (6 cycles / 12 months = 0.5 = 50%). An inventory turnover ratio of two would mean that the inventory is 16.67% liquid (2 cycles / 12 months = 0.1667 = 16.67%), and so forth.

Using the following table is a fast way to determine the level of liquidity for either inventory, accounts receivable or accounts payable for a company with 12 "risk-free" credit cycles per year:



Knowing the turnover ratios for inventory, accounts receivable and accounts payable we can apply the above percentages to calculate the dynamic current ratio.



ITR = Inventory turnover ratio
ATR = Accounts receivable turnover ratio
APT = Accounts payable turnover ratio<

Base on the example below, you will be able to appreciate the differences derived from the use of the various ratio calculation methods:

Example:

Since accounts payable are inserted in the denominator, and not the numerator as is the case with inventory and accounts receivable, the reading of 16.67% must be used in this example.

Using dynamic current ratio method:



Using conventional current ratio method:



Using quick ratio method:



Using cash ratio method:



Had we instead used the conventional current ratio (2.25) to do the same calculation, we would have overstated the company's short-term liquidity, and with the quick (0.58) and cash ratio (0.25) the company's liquidity would have been clearly understated.

Conclusion

The investor should be aware that management has to seek an optimum balance between the advantages of a high level of liquidity and the disadvantages of an excessively high accounts receivable turnover ratio. If the company has to offer large rebates in return for early payment and to employ a very aggressive credit department that places strains on management's relationships with its customers, credit terms may have to be reconsidered. The cost of lost customers is seldom measured, but the cost is very real and can far outweigh the gains made from higher short-term liquidity.

In turn, an excessively low accounts payable turnover ratio may lead to angry suppliers, and excessively high inventory turnover ratios may lead to supply shortages and angry customers. What might be right for one company may not be right for another. Credit policy terms and inventory turnover ratios should be viewed in light of what have been set out above and they should be compared to that of its industry and competition.

Although the dynamic current ratio represents an improvement over current liquidity ratios, the investor should be aware that ratios are only as reliable as the data on which they are based. Consequently, ratios should not be used as the only tool or source of information when analyzing financial statements, but should be supplemented with other sources of information, such as vertical and horizontal analysis.

However, the employment of dynamic current ratio is an accurate way of arriving at a more factual finding of a company's liquidity for those intending to examine the initial financial health of a company prior to consideration of investment.