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Liquidity ratios and solvency
You must also ascertain that your company has a satisfactory liquidity position, i.e. is able to free enough cash in order to repay its liabilities when they come due; note that a company may be solvent (i.e. able to repay its liabilities when it liquidates its operations) without being liquid. An example of this is provided by a company with very high receivables and no cash available: this company is wealthy on paper (since it is expecting to be paid a lot of money very soon) and is therefore solvent, but nonetheless remains illiquid since it is not able to free cash today (in order to repay a debt falling due today, for instance). In order to render this company liquid, one might want to sell its receivables to a bank, or securitize them (i.e. issue and sell financial securities whose value will be backed by the company’s receivables). Illiquidity may push a company to the brink of bankruptcy (and Bear Stearns was a striking example of a bank going bankrupt because of liquidity issues).
Three ratios are generally used in order to assess a company’s liquidity:
- the current ratio: is given by Current Assets / Current Liabilities, where Current Assets = Cash + Marketable securities + Receivables + Inventories. A current ratio smaller than 1 must be alarming or the company, as this means that it won’t be able to pay for its liabilities in the near future and thus will either have to refinance them, liquidate some of its activities in order to free some cash, or simply file for bankruptcy (which is equivalent with liquidating all of the company’s assets).
- the quick ratio (also called “acid ratio”): is given by (Current Assets – Inventories) / Current Liabilities. This ratio is eliminating the impact of Inventories on the liquidity position of the company. The principal reason for doing so is that Inventories are considered the least liquid among current assets.
- the cash ratio: is given by (Cash available and Marketable securities) / Current Liabilities. This ratio is seldom used in practice.
Similarly, and especially if you are a lender, you might want to determine whether the target company is solvent. Solvency denotes the ability for a company to pay back all its debtors after all the assets of the firm have been liquidated (after all its operating have been wound up). Saying that a company is solvent is equivalent with saying that its shareholder’s equity is positive (reciprocally, if shareholder’s equity is negative, i.e. if the company holds more liabilities than assets, then it is said to be insolvent).