I have written before
about the benefits of a rolling, 13-week cash flow projection in spotting and managing liquidity problems as they happen or are about to happen. But how does one spot liquidity challenges and their associated risks
The answer? Multiyear projections with a focus on liquidity.
Since I have also written previously about the importance of “look ahead” financial projections
, I won’t dwell on how to do those projections today. Rather, I will highlight
critical financial ratios that should be projected and tracked,
and that can be used to gauge liquidity risk in the future.
The most important ratios are those used by your lender
in the loan documents in the form of covenants (terms and conditions of loan policies). When calculating these ratios, always use the ratios as defined in you loan documents. There can be minor differences between lenders — even between loans from the same lender — and you want to ensure that your calculations are consistent with the agreements you have made.
Here are four ratios you will want to project and track…
#1. Fixed Charge Coverage Ratio (FCCR)
This ratio is an accounting definition of free cash flow divided by total financing payments.
A typical measure is Earnings Before Interest and Taxes, plus Depreciation and Amortization (EBITDA), less cash paid for non-financed capital expenditures, less cash distributed to owners for any reason, including taxes, all divided by the total of all interest payments and principal payments. Sometimes, lease payments are included in the denominator, particularly for retailers with leased real estate and/or businesses with lots of equipment financed by leases.
What is a “good” FCCR?
Small business lenders typically want a ratio higher than 1.2.
Larger loans and investment-grade bonds often want a much higher number.
#2. Current Ratio
The current ratio is simply current assets on the balance sheet divided by current liabilities.
The balance sheet should break out and identify current assets and current liabilities and subtotal them, so this basic ratio is easy to calculate, even for financial statement novices.
Current assets are typically those associated with working capital, such as inventory and accounts receivables. Current liabilities are those liabilities that are due within a year and include accounts payable, accrued payroll, and so forth.
In theory, the lower the current ratio, the worse things are.
That said, this ratio fundamentally assumes that all current assets can be easily converted to cash to pay current liabilities. In truth, a company with some illiquid current assets (out of season seasonal inventory or deferred taxes, for example) is in worse shape than a company with lots of liquid assets.
#3. Quick Ratio
The Quick Ratio, sometimes called the "acid-test ratio," takes into account the fact that some current assets can be converted to cash more easily than others.
For the numerator, instead of
current assets (as used in the Current Ratio), the Quick Ratio uses only cash and equivalents, short-term investments, and accounts receivables. These are the "quickest" assets that can be turned into cash to pay bills.
The Quick Ratio also has its shortcomings.
In particular, some accounts receivables can be converted to cash more quickly than others. For example, it takes longer to convert accounts receivables to cash in an industry with 90-day terms than in one with 10-day terms. In addition, some receivables may be subject to offset by the company's own purchases from their customer. The list goes on.
#4. Cash Conversion Cycle (CCC)
The cash conversion cycle is not a true ratio, as it is not measured as a percent, but rather, in numbers of days. In this case,
it is the number of days to take inventory, sell it, and collect the receivables —
the days the company uses vendors’ money before it pays vendors.
Cash Conversion Cycle = DIO + DSO - DPO
DIO = Days Inventory Outstanding
DSO = Days Sales Outstanding
DPO = Days Payables Outstanding
I'll spare you any more detail, other than to suggest that
a rising trend in CCC days is not a good sign for liquidity.
Note, by the way, the importance played by an increase in accounts payable — as it rises, inventory and accounts receivable become less of a problem.
watch for sudden changes in the components.
What might normally be a good trend may really be a warning sign. For example, days of payables increasing because there is not enough liquidity to pay vendors; or days of inventory decreasing because vendors are not shipping for lack of payment. Both are signs of financial distress.
A few tips on how to use these ratios:
Track these ratios for your business over time
and compare projected ratios against historical ratios. Obviously, improving ratios are better than the alternative (remember that seasonal patterns may have an impact).
When used with projections, these ratios give a sense of downside liquidity risk if things go wrong.
The tighter the ratios, the less wiggle room. Consider running projections and calculate these ratios when considering changes that impact working capital, such as inventory levels or customer payment terms.
These measures are used by creditors to evaluate debtors.
You can use them to track your customers, where appropriate, and to see how creditors, particularly banks, view you.
Use them to compare your business with competitors
. Use published financials for public companies. For private companies, industry-specific ratios are often available from various service providers. Consider differences in accounting methods, such as LIFO vs. FIFO for inventory. Then compare the homogeneity of operating units. Using ratios to compare two companies in different businesses is often of limited value.
Besides operating changes, consider making changes to your debt structure.
For example, extend the term of term loans to reduce principal payments, or increase the size of an interest-only credit line or revolver.
Always use judgment.
Ratios alone should not be used to assess liquidity, nor should one liquidity ratio be used in isolation of others.
Overall, when you take the time to understand these four simple ratios, you will reduce the likelihood of your company running into unexpected liquidity problems.
If the risk of future liquidity challenges is too high for comfort, take action and change plans.