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Liquidity – here’s why it matters now more than ever for investors

Liquidity matters now more than ever. Here’s why, and what it means for investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Nicholas Hyett
Equity Analyst

Published on 20 November 2020

This article is more than 6 months old

It was correct at the time of publishing. Our views and any references to tax, investment and pension rules may have changed since then.

If you’ve been reading our share research over the last six months or so, you’ve probably heard lots of references to ‘liquidity’.

Liquidity is all about how much ready cash a company can get its hands on at short notice. In normal times markets tend not to worry too much about liquidity. That’s largely because most companies can always borrow a little extra from the bank if they need it.

In a crisis though, companies often aren’t looking for a ‘little extra’ to bridge the gap – they’re after a whole load extra to keep themselves afloat.

That happens at just the same time bankers turn extra cautious on who they lend to. The combination of a company’s urgent need for cash, and bankers’ reluctance to lend often leads to a fatal crunch. It’s often said that ‘liquidity not solvency’ kills a business.

Liquidity vs. solvency – what’s the difference?

Solvency is about a company’s ability to meet its long-term debts and other financial obligations. This clearly matters a great deal. If a company’s debts increase, or profits fall to the point where loans can’t be paid, it’s likely to have to turn to shareholders for more cash.

However, solvency rarely changes quickly. Prudent banks and bond holders limit the amount they’re willing to lend to what they think a company can pay back. While profit can rise and fall a lot from year-to-year, the value of a company’s underlying assets tends to be more stable.

We measure solvency using metrics like a debt-to-equity ratio. This compares the amount a company has borrowed with the amount of shareholder value in the business. We also use net debt to cash profits. This tells us how many years profit it would take for a company to completely repay its debts.

By comparison, liquidity is about a company’s ability to meet its current (short-term) financial obligations.

Liquidity can change very quickly and, crucially, a liquidity crisis can hit a company that’s otherwise in good financial health. While a company facing solvency problems can turn to investors for help, a company which can’t meet its current financial commitments can be overtaken by events and quickly fall into administration.

Some tools for assessing liquidity

Liquidity is rarely at the top of an investors list of concerns in good times, and that means many don’t know how to assess it.

What’s important to remember is that not all assets are equally liquid. Cash is the most liquid, since it can be used to pay any expenses that arise at a moment’s notice. On the other hand, property is very illiquid, since it would probably take months to sell.

The task for investors is to work out which assets the group can call on quickly if needed, and how they match up against short notice liabilities (debts).

Fortunately, company balance sheets go some way towards helping us assess the liquidity of a company’s assets and short-term liabilities.

Balance sheets have four components. Current assets, non-current assets, current liabilities and non-current liabilities.

In order to be classed as current, an asset needs to be convertible into cash within a year. That includes cash, money owed by customers and inventory. Similarly, current liabilities are things the company has to pay within a year – short term debts, tax bills and payments to suppliers can all fall into that category.

Current ratios

Dividing current assets by current liabilities gives us something called the “Current Ratio”. A current ratio shows how well covered the company’s liabilities are by easily saleable assets.

Generally speaking, we think investors should be looking for a current ratio of more than 1. In other words, companies should have enough liquid assets to cover their expected liabilities. However, in a crisis lots of companies find their ‘current assets’ aren’t as liquid as they might have hoped.

Imagine a retailer who holds several million pounds worth of inventory. It’ll find it difficult to shift all that stock at very short notice without hefty discounts. That means its current assets are worth less in reality than they are on paper. The same is true for lots of other types of current assets. A current ratio of 1 might not be enough for investors to be really comfortable.

As a result, companies where current assets include very little cash, but lots of non-cash assets, are worth extra attention.

Quick ratios

To help with that, you might want to think about a “Quick Ratio”. Quick ratios are a rough and ready way of looking at the assets that can most rapidly be turned into cash. It’s calculated by subtracting inventory from current assets and then dividing by current liabilities.

The Quick Ratio is a more conservative measure of liquidity, and arguably better suited to the current scenario where sales are severely disrupted. The higher the ratio the better. But bear in mind, some inventory heavy businesses (like retailers) will always come out looking poor on this measure.

We think the two ratios are best used together. If the quick ratio looks low (under 0.5 say) then consider what the effect of a 50% reduction in inventory value would be on the group’s current ratio. If, after halving the value of inventory, the current ratio is still above 1 then that might give you some comfort the company has enough near-term assets to cover expenses. Even if it has to slap sales stickers on its stock.

No short cuts when doing research – but somewhere to start

In times of crisis, liquidity can become the key question on whether or not a company survives.

As ever there are no short cuts when it comes to doing your own research on companies. However, we think that using Current and Quick ratios can be a useful framework for investors starting to think about liquidity.

Current Ratio = Current Assets/Current Liabilities

Quick Ratio = (Current Assets – Inventory)/Current Liabilities

Both ratios can be easily calculated from numbers in company financial statements. And, if nothing else, they should help you better understand the near term risks that can exist in an otherwise solid looking business.

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