Understanding Business’ Cash Position Through Liquidity Ratios

Cash is King. One of the classic sayings in business and one of the great “truths” is that cash truly is King. Cash presents businesses with many opportunities: it can be seen as the ultimate reward for a business’ success, an opportunity to make additional investments or as security for an unknown future. Referred to as the “cash position”, it is a sign of financial strength and liquidity.

However, it is important to appreciate and understand that cash is not something that “just happens.” Cash is the ultimate symptom of a business as a lagging indicator of business performance. In short, cash is realized (or in some cases, not realized) only after a series of related events. Businesses need to be developed, sold, fulfilled, and then, administered. Only after this sequence of events is completed can a business collect cash.

From a more traditional financial perspective, a reader of financial statements can think of an Income Statement as a leading indicator of future cash. Admittedly, this is a simplistic perspective of the Income Statement and discounts planned investments, but at the end of the day, Net Income is a prerequisite for long term sustainable cash balances. The TGG Way has numerous Blog Posts dedicated to the subject of driving Net Income.

To extend the thought process of the Income Statement being a leading indicator for future cash, a reader of financial statements can use the Balance Sheet to understand how effectively the business executes the conversion process of delivering Net Income to actual cash balances. Key issues highlighted on the Balance Sheet include:

  • How quickly does a business collect receivables?
  • How efficiently does a business manage their pay cycle?
  • Were the investments required to deliver the Net Income reasonable relative to the return they produced?

All of these issues, challenges, and questions ultimately help management to understand if a business is in a positive, neutral, or negative position to fund near term obligations.

The most efficient and effective way to study a business’ liquidity position is to use ratio analysis and to review liquidity ratios in a graphic format with the current month compared against the prior 12 months.

Three of the most commonly used Liquidity Ratios include:

  1. Current Ratio: The current ratio is popular because it helps to answer one of the most fundamental questions: will the business be able to pay its bills? The Current Ratio is also very easily to calculate by dividing Current Assets by Current Liabilities. In most instances, a target of 2.0+ is the demarcation point for a business to be considered to be in a positive cash position.
  2. Cash Ratio: A Cash Ratio differs from a Current Ratio because it focuses almost exclusively on cash-on-hand compared to Current Assets. In a more simplistic perspective, the Cash Ratio is more stringent than the Current Ratio. The Cash Ratio is calculated by dividing Cash plus Cash Equivalents and Invested Funds by Current Liabilities.
  3. Cash Conversion Cycle (CCC): The CCC facilities a deeper understanding of how many days it takes for a company to convert resources into cash. The insight provided effectively demonstrated how many days a dollar is tied up in production, inventory, the sales cycle and the vendor payment cycle. CCC is calculated by adding the Days Inventory Outstanding metric to the Days Sales Outstanding and Days Payable Outstanding metrics.

To better understand these metrics or implement these ratios into your financials, call TGG Accounting today.

Written by:
Andrew Ruff
TGG Accounting

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