© 2000 John Petroff

A- Significance of liquidity

1)- Importance of liquidity to lenders

Liquidity is of great concern to lenders because they can reasonably expect to be repaid in much the same pattern as the borrowing firm has been paying its creditors in the recent past. Since a firm must meet its day to day obligations, the liquidity of a firm is an indication of its ability to repay a loan. Lenders indeed look for a high liquidity as their protection. As it has been indicated in Chapter 4 Section A and Chapter 4 Section B, suppliers and banks put much weight on this aspect right from the start.

See review questions Q-8A1.1 and Q-8A1.2.

See research assignment R-8.1.

2)- Importance of liquidity to investors, management and other view points

All those evaluating a firm must also be first concerned with liquidity: they need to be assured that the firm is a going concern, and default is not likely in the near future. But, as opposed to short term lenders who count on a firm's ready cash for payment of claims, from the point of view of investors and management, holding large cash balances is not necessarily desirable. Idle cash is costly to the firm: the firm forgoes the return it can earn on productive assets.

Holding cash or keeping on hand other liquid assets must have an intrinsic reason. For investors and management, these reasons are far more important than the ability to meet payments out of the cash generated from holding inventory or receivables. As already pointed out, receivables are part of the sales strategy of the firm. Most firms would prefer prepayments for all their sales, thus avoiding risk of customer default. They allow customers to take 30, 60, 90 days or more to pay for their purchases, only in order to encourage them to buy immediately rather than later. Likewise, inventory is held to offer greater product variety to customers (i.e. it is justified by sales strategy), and to allow the production process to take place without excessive discontinuity.

Holding cash can be justified not by needs to make immediate payments, but by needs for long run growth since flexibility must exist in the firm a) to undertake rapidly the most desirable projects, and b) to deal without major disruptions with unforeseen problems. The more a company seeks growth and faces risk, the more it must have a cushion of ready cash. Cash on hand is essential to take advantage quickly of new opportunities stemming from new products, changing customer tastes or changing market conditions. When a product failure or other catastrophe occurs, a healthy cash position helps handle the situation by closing a department and moving on to better opportunities.

While all firms should have a cushion of safety in holding a cash balance, that cash balance can be rather small for a company that has a long history of having solved its operational problems, and that faces a market with growth potential. The cash balance can be all the more limited if the company has also access to ready credit through good relations with its bankers. Moreover, access to capital markets reduces further the need to hold liquidity for larger firms.

See review questions Q-8A2.1 through Q-8A2.11

See research assignment R-8.2.

3)- Relation of liquidity analysis to other aspects of the firm performance

There is (or used to be) a tendency on the part of analysts to study liquidity of a firm as if it were separate from other aspects of analysis. In fact, it is not. Liquidity can be increased by several methods:
- liquidating some fixed assets,
- raising new permanent funds,
- increasing sales, or
- reducing costs.
If a firm has insufficient liquidity, any of these corrective approaches can be used in the long run (but not in the short run). For instance, bankers sometimes advise their borrowers with insufficient liquidity to increase permanent funds by injecting more equity into the business. This is the C standing for "capital" in the 5 C's of banking mentioned in Chapter 4 Section B-1. Indeed the new money will increase the cash balance (alternatively, it can be used to pay off some short term debt). This means that issues pertaining to liquidity will be seen again in chapters 10 and 11 where fixed assets and capital structure are studied.

Management is certainly concerned with liquidity, but it does not consider it as a goal in itself (i.e. not on the same level as goals such as profit and sales growth). As noted above, receivables and inventory are tied to sales and production strategies. Thus, when receivables or inventory are out of line (too much or too little), the cause is usually traceable to production, sales efforts, fixed assets or other management decision parameters, not liquidity alone.

Table T-9.1 below presents the normalized aggregate balance sheet of six US industries that will be studied in this chapter.

See review questions Q-8A3.1 through Q-8A3.4 .

See research assignments R-8A.1 and R-8A.2.

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Last modified: Jun/01/01

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