A business may be very profitable but have a cash crunch which can bring its activities to an abrupt halt
By Sunil K Parameswaran
An asset is said to be liquid if it can be bought and sold easily. In other words, if the asset trades in a liquid market, buyers can easily locate sellers and vice versa. Otherwise, if buyers significantly outnumber sellers, traders will have to hike up their prices in order to transact. On the contrary, if the market is dominated by sellers, then prices will have to be brought down before a transaction takes place.
One measure of liquidity is the bid-ask spread if the market for the asset is made by dealers. Dealers will typically give a two-way quote, that is, a price for buying, and a higher price for selling. The difference between the two is called the spread. If transactions are few and far between, the spreads will be high. Else, if the market is very liquid, then the spreads will be low.
Banks are also dealers. Their product is money. So, like other dealers, they too have a spread called the Net Interest Margin, which is the difference between their lending rate and their borrowing rate. If liquidity is tight the margin will be high. Else, if they are flush with funds, the margin will be low.
The central bank of a country has various tools for influencing liquidity. These include open market operations, which entails the purchase and sale of government securities, and adjusting the reserve ratios applicable for commercial banks. If the central bank buys securities, it injects money into the system and boosts liquidity. On the other hand, if it wants to reduce liquidity it can sell securities. In the case of reserves, if the central bank wants to reduce liquidity it will increase the reserve ratio. However, it wants to make more funds available to the banking sector for lending, it will reduce the reserve ratio.
Companies and corporate analysts use certain key ratios to gauge liquidity. The first is called the current ratio. It is the ratio of current assets to current liabilities. Current assets are referred to as working capital and current assets minus current liabilities as net working capital. Thus, if the current ratio is greater than one, then the net working capital will be positive, else it will be negative. If the net working capital is negative, it means that to an extent, long-term assets are being funded with short-term liabilities.
This can be a problem because short term liabilities have to be repaid quickly whereas long-term assets can be hard to sell. A more stringent measure of liquidity is the quick ratio or the acid-test ratio. It is computed by subtracting inventories from the current assets, and then dividing by the current liabilities. Thus, the quick ratio will be lower than the current ratio. The rationale for subtracting inventories is that of all the current assets on the balance sheet, they are the hardest to convert to cash.
Liquidity is paramount for a business. In the long-run a business that is not profitable will collapse. In the short-run a business without adequate liquidity is likely to fold up. Profit and cash are not the same. Thus, a business may be very profitable, but have a cash crunch which can bring its activities to a grinding halt.
The writer is CEO, Tarheel Consultancy Services