Analyzing the Liquidity position of a firm

Liquidity is simply a company’s ability to meet obligations on time.

The liquidity of an asset, as determined by the economic factors affecting supply and demand, varies with the type of asset and, in some cases, with time. For example, certain government securities can be realized overnight while some receivables can be realized in 30 days or less but it takes longer to sell a large industrial building.

Liquidity is important because it sustains the ability of an enterprise to meet its obligations in a timely manner. As an analyst, it is vital to understand this concept since the definition of insolvency is the inability of a firm to meet its obligations as they mature. The penalty for lack of liquidity is very high, including the possibility of bankruptcy if the creditors attempt to collect through the courts.

Installing timely management strategies can increase asset liquidity. For example, payment delays may be reduced by the efficient credit and collection procedures or inventories that may be sold faster if they are advertised and promoted or even if they are perceived to be of higher quality than the competition.

Liquidity also affects the structure of the balance sheet. The asset accounts are listed in the order of their liquidity i.e. current assets first, fixed assets second and other assets in the last. Individual current accounts are also ranked by their degree of liquidity. For instance, cash is the most liquid account and is, therefore, listed first among the current assets.

Types of capital

Working capital

Working capital is the number of resources available to meet a company's day-to-day needs, such as paying expenses or debts incurred to purchase current assets. The difference between current assets and liability determines the amount of working capital i.e. the net current asset on the balance sheet. In accounting terms, it is the part of current assets that are not financed by the current liabilities. In general, the greater the amount of working capital, the greater the liquidity. In unit four, we will demonstrate that the current ratio, which represents the coverage of current assets over current liabilities, is a traditional measure of liquidity.

The amount of a company’s working capital may be positive or negative. We can determine this by subtracting current liabilities from current assets. Working capital=current assets-current liabilities. If current assets are greater than the current liabilities, working capital will be positive. If current assets are less than current liabilities, working capital comes out to be negative.

The timings of the cash flows are equally important. The definition of working capital is somewhat generalized because it is based on volume only. A better measure of a company's working capital also includes the element of time. Time indicates as to when inflows and outflows will take place in all asset and liability accounts. Time and volume together provide a more exact picture of a company's working capital.

Permanent capital

Permanent capital, in a generic sense, is comprised of non-current assets (e.g., land, buildings, furniture, equipment, etc.) in relation to long-term liabilities (e.g., long-term debt, etc.) and shareholders’ equity (net worth). Non-current assets should be funded by long-term financing or permanent funds.

We know that net worth is the interest investors have in the assets of an enterprise after satisfaction of liabilities owed to the company's creditors. Net worth represents an important part of a company's permanent capital and should be used to support fixed assets and investments. Any excess of net worth over fixed and other non-current assets is then available for funding working capital.

If net worth is lower than permanent assets (fixed assets), the difference on the balance sheet will be funded by outside capital. This outside source of funds will also cover the working capital financing needs. The following example of ABC Company illustrates this point.

Notice that there is a difference of Rs 50 between the net worth and fixed assets. Since net worth is greater, the difference (Rs 50) in effect serves to provide funds for the working capital. The proportion of a company’s own resources used for funding fixed assets is greater than 100 per cent, so 14 per cent of net worth is used to fund the company's working capital.

Now suppose, ABC Company purchases a new plant for Rs 100, it will be financed by long-term loans.

Fixed assets increase from Rs 300 to Rs 400 and total long-term liabilities increase by the same i.e. Rs 100. Fixed assets are now covered by Rs 350 in net worth and by Rs 50 in long-term debt. Since the entire net worth is used to cover fixed assets, the current assets are funded entirely by outside capital.

Third-party capital

Outside capital represents the company's indebtedness to third parties and represents obligations to pay sums of money at some future date. Third-party capital may be classified as:

Current liabilities:  liabilities maturing within one year and,

Long-term liabilities: liabilities maturing after one year

Own capital

Own capital represents the owners' investment in the company plus the wealth accumulated by the company from its business earnings. It is divided into:

Paid-in capital: It is the amount actually invested by the owners, which usually remains in the company forever. It is only returned to the owners, in whole or in part that too, in very rare cases i.e. when a company is dissolved or its capital reduced.

Retained earnings: It is the wealth accumulated by the company as a consequence of its profitable operations over a number of years. Eventually, retained earnings are capitalized or paid out as dividends. The companies with unprofitable operations have accumulated losses. Many companies have unprofitable periods now and then, but in grave situations, the company may need additional capital injections to prevent insolvency.