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Liquidity Analysis

While we are discussing financial concepts, lets cover one more - working capital. There are many companies that are asset rich, but cash poor.  Sometimes we need to help our customers find the money to buy our products or services. This discussion may help.

Liquidity measures the ability of a farm business to meet financial obligations as they come due in the ordinary course of business, without disrupting the normal operation of the business. 

Two measures of liquidity are frequently used. Those two measures, along with their calculations, are:

current ratio = total current assets / total current liabilities

working capital = total current assets - total current liabilities

Both ratios can be calculated directly from the balance sheet. 

The current ratio is a relative measure, allowing one business to be compared to another. 

  • Current assets are those that are due to be converted into cash within the next 12 months, such as accounts receivable and inventories. 

  • Current liabilities are those that are due to be repaid within the next 12 months, such as accounts payable, accrued interest, operating loans, and the principal due on term notes within the next twelve months. 

A current ratio of 1.25 is often considered the minimal acceptable level for cashflow purposes.

Working capital is an absolute measure that should not be used for inter-business comparisons. How much is enough varies from business to business. A full discussion of working capital is beyond the scope of this discussion, but the common measure of working capital, current assets minus current liabilities, while useful as a quick calculation method, detracts from the user's understanding of the concept. 

Like a bikini, it reveals much that is interesting, but conceals that which is vital. 

Just as the Dupont model departs from the traditional formula, an alternative approach may be taken which makes more clear what working capital is, based on where it comes from and what it is used for..

The usual definition of working capital of:

Working Capital = Current Assets - Current Liabilities

may be manipulated through balance sheet equations to derive the formula:

Working Capital = Long term debt + Net Worth - Fixed Assets

The formula derived has great power in analyzing and understanding the sources and uses of working capital. A change in working capital is caused by a change in one of the three elements.

Net worth:

Sources: profits, i.e., accrual income, after taxes, additional capital investment into the company, appreciation of assets (although an increase in the value of an asset would not show up under general accepted accounting principles until the asset is sold and the income realized)

Uses: losses, dividend payments, family living withdrawals, other withdrawals or distributions of capital, buying company stock and holding as treasury stock or retiring it, declines in the value of assets (although an decrease in the value of an capital asset would not show up under general accepted accounting principles until the asset is sold and the loss realized, unless the valuation change must be reported for an asset placed on the balance sheet at the lower of cost or market value, such as inventory)

Long-term debt:

Sources: new long-term debt (that is, the long-term loan amount, less any principal due within the year (the current portion) which would be classified as a current liability)

Uses: principal payments on term debt

Fixed and other assets:

Sources: sale of fixed assets, depreciation of fixed assets

Uses: purchase of fixed assets, investment in long-term business assets

When a prospective customer says "I just don't have the cash to pay for your product or service" now you know where to help him or her look for the money.  

If you can make the compelling case that your product or service will generate more revenues than expense, that it will improve his or her bottom line, the short term shortage of cash cries for a solution.  It just doesn't make sense that a business can't afford to make more money. 

All of the possible sources of working capital should be explored for the long term benefit of all involved.  Perhaps you can be the one to provide the solution, whereas competitors may just walk away from the sale.