Taking Stock: Liquidity May Mean The Difference Between Survival And Death

Liquidity in the stock market generally means how many shares trade hands in a day. IBM and Intel have lots of liquidity, as there are many buyers and sellers. However, if there are few buyers or sellers, a publicly traded company may be relegated to the pink sheets, the daily listings of price quotes for the over-the-counter marketplace.

At the company level, liquidity means a lot more. As Qwest Communications and Tyco International learned, liquidity may mean the difference between survival and death. Liquidity analysis is used by many banks and other lenders to assess the short-term risk of a company's ability to pay its bills. Investors will look at trends in a company's quick ratio, current ratio, and cash ratio.

The quick ratio is a conservative measure of liquidity based on a fraction. The numerator is the sum of cash and equivalents, marketable securities, and accounts receivable. The denominator is current liabilities, which includes short-term debt, accounts payable, and accrued liabilities.

The current ratio is a measurement of cash resources relative to the short-term level of obligations.

It's measured by the fraction of all current assets divided by all current liabilities. Current assets are defined as cash and equivalents, marketable securities, accounts receivable, inventories, and prepaid expenses.

The most conservative ratio is the cash ratio, which is the sum of cash and marketable securities divided by current liabilities. Look at the business cash cycle, which is usually measured in days based on the average number of days inventory stays in stock (cash tied up in inventory) added to the number of days receivables stay outstanding (the credit terms you give a customer to pay their bill to you) minus the number of days payables stay outstanding (how long you hold cash before paying your bills). If the cash operating cycle keeps expanding, this is a big warning as to a company's short-term liquidity.

The other side of liquidity is debt structure. A company's capital structure is relevant to its long-term survival. Long-term creditors will usually put restrictions on additional debt and dividend payments to protect their interests. The greater the proportion of debt to equity on the balance sheet, the higher the business risk.

One of the first measures we look at is debt to total capital. Total capital is debt plus equity. The importance of these ratios should be compared with industry norms, not against all businesses. Media companies wouldn't be treated the same as basic industries. A company's ability to meet its debt payments is measured by times interest earned. Times interest earned is measured by earnings before interest and taxes (EBIT) divided by the total interest cost. A more aggressive ratio is EBITDA (which adds back the noncash, short-term costs of depreciation and amortization), and then is divided by total interest cost. There also are more conservative ratios. However, none of these measures mean much if the company can't sustain a profit. Fortunately, most IT managers are already aware of many of these issues when they review their long-term vendor relationships.

Let me also point out that much of what's going on is more a function of irresponsible management and the fact that Wall Street has given too much value to the stability of earnings rather than a truthful representation of business cycles.

Though corrupt auditors may be to blame in some cases, generally accepted accounting principles are meant to be flexible to account for different business practices. What needs to be clearly understood is that senior management is responsible for representing fairly to investors the financial condition of the public company. The auditors, subject to disclosure of management, are to confirm that the numbers are accurate and a fair representation of the business.

As we've seen in the news the past couple of months, fair representation may be interpreted quite broadly. Clearly, investors should be spending a little more time looking at a company's financials in detail. If nothing else, it will cure you of insomnia.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at [email protected].