Chapter 10

Aggregate Liquidity
Presentation by
Khaleda
Khatun
The firm’s Level of Aggregate
Liquidity:
• The overall relationship between a firm’s potentially available cash and its potential cash needs (for liabilities)
is known as a firm’s aggregate liquidity position.
• This liquidity position represents a firm’s gross hedge as larger volume of current assets can provide much
more cash than is needed for meeting cash needs for:
• (1) current liabilities and thus
• (2) minimize cash stock out situation.
• Need for measuring and managing aggregate liquidity:
• A firm is required to measure and manage its aggregate liquidity position as it has significant risk and return
implications
for this gross hedge.
• On the other hand, the amount of current debts relative to current assets affects shareholders wealth
or expected cash flow along with its risk.
• Therefore, assessing and managing these potential variations are necessary for proper financial management
point of view. Proper management of a firm’s liquidity requires proper measurement of its liquidity position.
• Moreover, these measurements of liquidity do also facilitate other firms in credit granting decision in favour
of the firm.
• Therefore, measurement and management of liquidity is an important working capital function of a firm.
Traditional Measurement of
Liquidity:
• Liquidity can be thought of as the firm’s ability to quickly generate cash
versus the firms need for cash on short notice. In general, for financial ratios are
used as the measure of liquidity for a firm and Financial statements are the
basic sources of information.
• These ratios are discussed as under:
• Current ratio: Current ratio refers to the relationship between current assets
and current liabilities. The current assets and liabilities are determined by the
accounting convention which states that an asset or a liability is said to have short
term or current nature if its maturity date is less than a year. One problem of current
ratio is that it mixes assets and liabilities of widely different maturities with equal
weight. For example, inventories are quite illiquid assets which in general is needed
to be converted in to accounts receivable and than in to cash.
• CR= CA/CL
• Relationship b/w CA and NWC:
• (+) NWC means CR grater than 1
• (-) NWC means CR less than 1
Traditional Measurement of
Liquidity:
• Quick or Acid Test Ratio: In order to minimize the inventory
lag effect, the quick ratio or acid test ratio basically uses very
short notice assets. These include cash, marketable securities
and accounts receivable as major current assets and attempt
to measure a firms liquidity position in terms of overall current
liabilities.
• QR= (CA-Inventory – prepaid exp)/ CL
Traditional Measurement of
Liquidity :
• Accounts Receivables Turnover (ART): This ratio
(Credit Sales divided by Average A/c/Rec.) indicates how
frequently a firm can convert its credit sales into cash.
Another related measure is the average collection period.
• Average Collection Period (ACP/ DSO): ACP is found by
multiplying the number of days in a year (360 days) by the
inverse of Accounts Receivable Turnover (ART). Thus, higher
the ART, the lower will be the ACP and better can be called
the firms liquidity position.
• DSO (Receivable conversion period)
Traditional Measurement of
Liquidity:
• Inventory Turnover Ratio (ITR): This is computed as cost of
good sold divided by average size of inventory of the firm. This
ratio implies that higher the ratio the quicker will be nearness
of inventory to be converted into cash. That is higher ITR
implies greater degree of liquidity.
• Day's inventory held( DIH) is found by multiplying the number
of days in a year (360 days) by the inverse of inventory
Turnover (ITR). (DIH time needs from production to sale).
• DIH (Inventory conversion period)
Exercise on measuring aggregate liquidity
 Traditional Measurement of Liquidity

• The all four measures of liquidity mentioned above are known as

traditional ratio approach to estimate liquidity position of a firm.
Although these ratios are very easy to measure and most popularly
adopted worldwide, but these sometimes lead to contradictory results.
These situations can better be understood with the help of an
illustration given in page 355 of your textbook. The key ratios are given
below
• Current Ratio = 140,000/170,000 = .82
• Quick Ratio = 65,000/170,000
= = times
20 .38
• A/C Rec. Turnover per year
=1,000,000/50,000
= 12 times
• Inv. Turnover = per year
Traditional Measurement of
Liquidity
• Given the above situation, suppose that a better inventory
management technique have reduced the firm’s inventory
investment to Tk. 50,000 level from current Tk. 75,000 level.
The firm uses this cash savings in paying a part of its long-term
liabilities, thus the current ratio of the firm declines from 0.82 to
0.79. Does the new current ratio imply a worse liquidity
position? In fact, the firm’s liquidity position has been improved
along with lower long -term liabilities. This better situation is
reflected in the higher quick ratio of 0.45 instead of previous
0.38. Thus, this contradictory signal needed to be assessed
cautiously. Other wise misinterpretation may lead towards a
Sophisticated Techniques for Measuring Aggregate
• In the previous discussion, we learnt about the traditional approaches to measure aggregate liquidity. Now
Liquidity:
we are going to examine some improved techniques developed during mid seventies to mid eighties. These
techniques can over-come most limitations of the traditional techniques and yet give a comprehensive insight
into a firm’s liquidity position. These techniques are discussed in brief as follow:
•
Cash Conversion Cycle: Developed by Richard & Laughlin in 1980, this technique attempts to identify the
• average time taken by a firm to convert its account receivables and inventories into cash flows using
Spontaneous sources of funds.
• According to this model, the lower the cash conversion cycle, the more liquid is the firm & calculated
by using the following formula:
•
Cash conversion period/ Cycle( CCC/CCP) = Average collection period (DSO) + inventory conversion
period (DIH) – payment deferral period (PDP)
• (b) Payment deferral time.

• The model has

The operating two-timed
cycle segments:
time includes days inventory held plus average time required to convert account
• (a) Operating
receivables intocycle time and
cash
• or average inventory conversion period + the average collection period or Operating Cycle
• The Average Inventory Conversion Period formula (DIH) = Inverse of Inventory turnover Ratio
• X 360 days, Average collection period (DSO)= Inverse of A/C Receivable Turnover x 360days
The Payment Deferral Period
formula
Payment Deferral Period = (Sum of A/C Payables and sales related other Payables) X
360 days Sold
Cost of
good

• The Payment Deferral Period implies that average time that a firm keeps its short -
term liabilities unpaid. From the example in page # 355 of your text, the cash
conversion cycle can be computed as follow:
• Cost of Sales Tk. 900,000
= = Tk.
• Accounts Tk.110,000
Payables 60,000.
• Inventory Turnover Ratio = 12
• Wages
times Payable
=
•• A/R Turnover
Operating Ratio
Cycle Time (360 = 20360)
+ = 18+30 = 48
times
= days
20 12
• Payment Deferral Time 110,000+60,000) X 360 = 68 days
900,000
• Thus, the Cash Conversion cycle = 48 – 68 = -20
days.
The Payment Deferral
Period
• This implies that the firm can defer its short- term funds longer
than its operating cycles and have excess provision for
liquidity. But this model ignored:
• (a) The cash balance of the firm, and
• (b) Also failed to address the issues as to what will
happen if its suppliers/labour demands quicker
payments.
• In those cases, this firm will experience real bad liquidity
crisis and may even loose its long- term credit rating.
Comprehensive Liquidity
Index:
• This is a modified current ratio approach.
• As you can remember from traditional current ratio, that, all
assets and liabilities were given equal weight irrespective of
their maturity period.
• In order to over come that limitations, Melnyk and Birati
developed this modified current ratio approach which they
named as: Comprehensive Liquidity Index (CLI).
• Under CLI all the current assets and liabilities are adjusted by
a factor known as (1 – Inverse of the Turnover Ratio of the
asset or liability).
• The index is the current ratio computed from modified current
assets
Comprehensive Liquidity
Index:
• Thus, using the information from the previous example, the modified current
assets and liabilities are computed as follows:
• Cash = Tk. 15,000 (No adjustment for maturity)
• Modified A/c. Rec. = Tk. 50,000 {1 – (1/20)} = Tk. 475000
• Inventory = 75,000 {1 – (1/20) – (1/12)} = 65,000
• [The inventory needs double adjustment as it first is converted into A/R and than
into cash].
• Thus, modified current asset of the firm (X) =
• (15,000 + 47500 + 65000) = 127,500.
• If the firm in our example purchase inventory worth 400,000 a year with
average A/C payable = 110,000.
• The A/C payable turn over ratio = 400,000 ÷ 110,000 = 3.64 times modified A/C
payable = 110,000 {1 – (1/3.64)} = 79750.
• When wages payable = 60000 with the total wage bill of 500,000, the wage
payable turn over ratio = 500,000 ÷ 60,000 = 8.33 times.
Comprehensive Liquidity
•Index:
Modified wage payable = 60,000{1- (1/8.33)} = 52,800
• Modified current liabilities (Y) = 79,750 + 52,800 = 132,550
• So, Modified current ratio or comprehensive liquidity Index
• 127,500 /132,550 = 0.96
• Thus, from the CLI we can understand that the firm in
question has bad liquidity position in term of current ratio,
• However, when these assets and liabilities are modified interns
of their maturities, the liquidity situation is slightly improved
implying the fact that, the firm’s current assets have better
maturity position.
 Net Liquid
• Considers cash and marketable securities as firm’s true reserve against unanticipated cash
Balance:
needs, as other remedies for cash shortages can be very costly.
• For e.g. if the firm runs out of cash, it might try to liquidate inventory via a distress sale, but this
would generate costs that would not otherwise occur. Or borrow money at higher interest rate
to avoid default.
This measure considers A/c Receivable & Inventory as additional assets to be financed.
• The A/c Payable and other accruals that are part of current liabilities are treated not as maturing
obligations but as part of the firm’s permanent financing package (like long term debt).
• Only notes payable (short term – interest bearing debts) are treated as maturing obligation.
• NLB = (Cash + Marc. Sec – Notes payable) / Total assets
• 15,000/290,000 = .052 or 5.2%
• (Here this firm has no Marketable Securities or notes payable)
• (-) NLB indicates dependence on outside financing and suggests the minimum capacity needed
from a credit line. (-) NLB does not mean that the firm will default on debt obligations. It implies
reduced liquidity.
• NLB=NWC-WCR
• WCR= current operating assets (noncash CA) – current operating liabilities (A/P and other
Lambda
• In 1984, a Professor Gary Emery at the University of Oklahoma developed a
Index:
tool that can be used to measure a firm's liquidity.
• Emery designed a liquidity risk measure specifically for credit managers.
• The tool was characterized by the Greek letter ƛ, which is pronounced "Lambda.
• Lambda was selected due to its phonetic relationship to liquidity.
• This approach is quite different from all the previous approaches in different
respects as stated below:
1. The firm’s available credit line (if known) is counted as part of the firm’s package
of liquid reserves.
2. This index uses a measure of uncertainty to evaluate the firms’ potential need for
liquidity.
3. This is the only measure that incorporates the firm’s expected cash flows in addition to
its cash & near cash stock of assets.
4. Lambda considers all cash flows regardless of whether they originates from short
terms or long- term transactions.
5. It assumes random cashflows and normal probability distribution
 Lambda Index Formula and
•• Lambda =
Example:
Where initial reserve = Cash + Marketable Securities + Available Line of credit
Therefore, if a firm has opening cash of $ 15,000, E(NCF) 75,000 with σ =
35,000

‫؞‬ƛ = (15000 + 75,000) /35,000 = 2.57

• The Measure of Uncertainty here is the Standard Deviation of the Expected Cash flow.
• The Lambda Index works like a Z score in a standard normal distribution.
• As a Z score indicates, the probability of occurrence of any event, given an expected value, the Lambda
measures the probability of cash shortage at any point of time.
• Therefore, in the above example, the Lambda is found to be 2.57.
• If we look at the Table value of the Z score, we will find the table value is: 0.0051.
• What is the meaning of it?
• The table value suggests that, given the standard deviation of 35,000, we have less than 1% (0.51%)
probability cash shortage.
• That is, in this example, with an initial cash flow of 15,000 and expected net cash flow of 75,000, the firm’s cash
ability to pay its short-term debt obligations is (100 -.51) = 99.49% when the standard deviation of expected
cash flow is 35,000.
• Therefore, on a standard precaution, when a firm has a Lambda of more than 1.96, it can remain confident
about its cash balance sufficiency.
 The Lambda Index: Beyond the Current
Ratio
• Liquidity measurement is an important part of credit analysis.
• Analysts measure liquidity to assess the quality of new credit
applicants and to monitor the solvency of current customers.
• For either purpose, this assessment must be based on a measure
that is practical, understandable, and a reliable indicator of a
company's ability to pay its bills.
• The traditional financial ratios used to measure liquidity include the
current and quick ratios and various working capital turnover ratios.
These measures have been popular because they are familiar and
easy to apply.
• Unfortunately, they are not very effective because they fail to
account for all the factors that effect a company's short-term
Source: Business Credit (MAGAZINE ARTICLE), By Emery, Gary W.;
solvency.
Lyons, Ronald G.
Liquidity is Affected by Many Factors
• The amount of financial resources available in times of distress is the first
factor that effects a company's liquidity.
• These resources must be quickly convertible into cash to ensure that the firm
can meet an unexpected requirement for funds.
• Furthermore, their use must not disturb operations so future liquidity is not
impaired.
• Cash, marketable securities, and the unexercised portion of lines of credit are the
principal resources that meet these requirements and must be included in the
liquidity measure.
• The second factor that effects a company's liquidity is the amount of its
future cash flows.
• Cash inflows increase a firm's liquidity position while cash outflows diminish it.
• These effects must be recognized to assess the adequacy of a company's financial
resources.
• This is accomplished by including anticipated future net cash flows in the liquidity
measure.
• Future net cash flows cannot be predicted with certainly, however,
Traditional Liquidity Measures Are Inadequate
• The deficiencies of the traditional liquidity measures are readily apparent when they are
examined for the factors the effect a company's liquidity position.
• We'll use the current ratio as an example to illustrate these deficiencies, which is like other
traditional measures as well.
• The current ratio is defined as current assets divided by current liabilities.
• The numerator of this ratio purportedly measures a company's liquid resources, but it is inaccurate for two
reasons.
• First, current assets include inventory and receivables which are not quickly convertible into cash.
• Second, current sales exclude lines of credit which are an important source of liquidity for many
companies.
• Current assets, therefore, overstate or understate a company's actual liquid reserves,
depending on which error is more significant.
• The denominator of the current ratio purportedly measures a company's cash requirements,
but current liabilities is a poor substitute for cash flow.
• All companies have cash requirements that are not recorded on the balance sheets and
cash inflows that partially or completely offset their cash outflows.
• This means current liabilities understate or overstate a company's actual future cash
requirements, depending on which omission is more significant.
Limitations of the Modern Approaches

• Therefore, modern approaches are improvements over traditional

approach.
• However, all these four tools have some limitations, specially
when these measures are used to measure liquidity of other firms;
like-
1. Off-Balance Sheet relationship
2. Current portion of Long-term debt
• Existence of off-balance sheet liquidity factors like hidden reserves
(existence of highly liquid fixed assets) may be used in case of
emergencies. On the other hand a seemingly good liquidity position
may be seen useless on unforeseen occurrence like law suite or
bankruptcy of the major client firm.
• An un-reported current portion of a long-term obligation can
create a blind- spot to other firms, which wants to assess its liquidity.
This may not be known to outsiders.
 LIQUIDITYAND THE FIRM’S FINANCIAL MANAGEMENT PROCESS
Now that we have developed measures of the firm’s aggregate liquidity
position, so, can talk about the management of that position within the firm’s
financial management process. The financial management process involves
following steps:
• The firm decides what assets, current and long-term, it wants to hold using
methodologies related to shareholder wealth maximization.
• The firm decides on a target structure of financing based on a desired ratio of total
debt to total assets
• The firm decides on a target level of aggregate liquidity. This decision may be
based on a desired index of aggregate liquidity (such as the current ratio. Cash
Conversion Cycle, Comprehensive Liquidity Index and so forth). In doing this, the firm may
evaluate several potential positions to determine the appropriate target. Once the
aggregate level of liquidity is chosen, the firm determines a target structure for its
current and long-term debt
• The firm compares this plan with its present financial structure and makes
necessary and cost- effective adjustments to move toward the targeted financial
structure.
 LIQUIDITYAND THE FIRM’S FINANCIAL MANAGEMENT PROCESS
• Genu Splice wants to plan a future financial
position
 • Step 1: The firm has assed its desired level of assts is $270, fixed assets must be
LIQUIDITYAND THE FIRM’S FINANCIAL MANAGEMENT PROCESS

increased by $20 million. Firm decides an additional investment of $ 10 million is also

required for accounts receivables
• Step 2: The firm decides its desired debt-to-assets ratio is

0.60. So, total debt= $270x.6= $162, Equity = $ 270x.4=

$108
• Step 3: Firm requires to set a target aggregate liquidity level and current debt structure.
Assume that firm has used the current ratio as its measure of aggregate liquidity which
is 2:1 .
So, as CA= $140, CL=$70 million
• Assume that this plan requires $ 10mill A/P, $30mill accrued wages, and $ 30 mill
short- term bank borrowings.
• The firm would then compare these desired positions in its assets and liabilities with its planned
positions and make cost effective changes to move toward its desired future financial structure
(step 4). In this very simplified example, over the planning period the firm would consider
purchasing $20 million in fixed assets, increasing accounts receivable by $10 million, retiring $8
million in long-term debt (since the desired total is
$92 million and the present total is $100 million), issuing $53 million in equity, lengthening
 EVALUATING STRATEGIES FOR AGGREGATE
LIQUIDITY
• 1. Expected level of interest payment-The use of more
permanent, short-term debt (with this debt refinanced as it
matures) and less long- term debt will generally reduce the
firm’s cash outflows for interest expense.
• Variability of interest expenses--the strategy of more shor-
term debt and less long-term debt involves higher risks.
• Cash Shortage Risk --Another risk associated with the use
of more short-term debt and less long-term debt is the cash
shortage risk that accompanies the lower liquidity in this
strategy.
EVALUATING STRATEGIES FOR
AGGREGATE LIQUIDITY
Conclusion

• Finally, credit analysts often compare a company's current ratio

to the average for its industry, but this is an imprecise way to
assess risk. The reason is that the current ratio ignores cash
flow uncertainly which varies among companies in the same
industry and across time.
• These deficiencies in the current ratio make it an unreliable
indicator of a company's ability to pay its bills. An analyst
cannot say, for example, that a company with a current ratio
of 2:1 is twice as likely to remain solvent as a company with a
ratio of 1:1. The former company may be more liquid, but this
conclusion is subject to many qualifications.
• Standard Normal Table given in next slide
Normal
Distributio
n Table: