Analyzing liquidity using the cash conversion cycle

A good assessment of a company’s liquidity is important because a decline in liquidity leads to a greater risk of bankruptcy. FASB describes liquidity as reflecting “an asset’s or liability’s nearness to cash” (Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises). Creditors often incorporate into loan covenants minimum measures of liquidity that borrowers must maintain. Investors and analysts are interested in a company’s ability to generate cash and to have enough cash available to meet everyday demands, and vendors are interested in whether a company will regularly have cash available to pay for purchased goods. Liquidity is also important to external auditors for responsibilities such as assessing issues of going concern.

Given the growing emphasis on risk assessment within companies, public accounting practitioners performing such engagements, as well as internal auditors, could also benefit from reliable measures of liquidity in helping management to better understand vulnerabilities.

In assessing company liquidity, the most commonly used measure is the current ratio and its variations, such as the quick/acid-test ratio. These measures, however, fail to incorporate a measure of “nearness” to cash described by FASB beyond the fact that “current” generally indicates that the assets will be converted to cash or consumed during the normal operating cycle of the business, and the liabilities will be liquidated using current assets, or by the creation of other current liabilities. Nevertheless, in accounting and auditing textbooks, the current and quick ratios continue to be the focus of liquidity analysis.

Noticeably absent from almost all accounting and auditing textbooks is an approach to liquidity analysis that incorporates the element of time—the cash conversion cycle (CCC), which was introduced in 1980 by Verlyn Richards and Eugene Laughlin in their article “A Cash Conversion Cycle Approach to Liquidity Analysis,” Financial Management, Vol. 9, No.1 (Spring 1980). Consideration of the CCC along with the traditional measures of liquidity will lead to a more thorough analysis of a company’s liquidity position.

This article describes the CCC approach and demonstrates how static measures of liquidity can be misleading if used exclusively, while the CCC can provide a useful complement in assessing company liquidity and hence (as prior studies have shown) profitability and stock returns. This is demonstrated by focusing on a comparison of Best Buy and Circuit City during the 10 years leading up to Circuit City’s 2008 bankruptcy filing.

STATIC MEASURES OF LIQUIDITY

Static measures of liquidity, such as the current and quick ratios, have certain advantages over the CCC. Namely, the static measures are quick and easy to compute, and they focus on the impact on liquidity of all current liabilities, whereas the CCC only focuses on the impact of accounts payable. The static measures, however, are deficient in many ways, and the CCC addresses many of those deficiencies, making it a useful complement in liquidity analysis.

A major disadvantage of the static measures is that they are measures of liquidity at only one moment in time. With the exception of holdings of cash and cash equivalents, liquidity depends on the relationship between inflows of cash and required outflows of cash that occur over time. Static measures do not account for the amount of time involved in converting current assets to cash or the amount of time involved in paying current liabilities, as the FASB definition of liquidity discusses. Furthermore, financial statement users cannot ascertain what a company’s current ratio was even the day before the financial statement date. The current ratio measure can be easily manipulated by any company wishing to report a higher ratio. Consider the following example.

A company has $1,000,000 in current assets and $750,000 in current liabilities. The current ratio reveals that the company can cover current liabilities with current assets 1.33 times [$1,000,000 ÷ $750,000]. If the company wishes to maintain a higher current ratio or if a creditor’s loan covenant requires a higher current ratio, the company could pay $500,000 of its current liabilities. The company would then report $500,000 of current assets and $250,000 of current liabilities.

The current ratio is now 2.0 [$500,000 ÷ $250,000], but this action could have actually harmed the company’s liquidity position, leaving it with $500,000 less cash to meet unexpected needs. Furthermore, if those current liabilities were not due for another month, then the company’s desire to report a better current ratio could have cost it a month of interest-free financing of liabilities and a month’s return on the cash that could have been invested elsewhere.

A high current ratio will also result from buildups of accounts receivable, a situation that is not necessarily desirable. The effects of lengthening the collection period of receivables, an act that harms company liquidity, would not be readily apparent in either the current ratio or the more conservative quick ratio.

Another disadvantage of static measures of liquidity is that, despite how simple they are to compute, they can be quite difficult to interpret. Higher is generally considered better, but too high may indicate inefficient use of assets. Lower is generally regarded as unfavorable but may actually be the result of efficient use of working capital.

A current ratio of approximately 1.0, which would indicate that the company is barely able to cover current liabilities, does not necessarily indicate a weak liquidity position if the company manages its working capital with such precision that the inflows of cash can be matched with the required outflows of cash. Of course, such situations are also potentially treacherous because a positive overall cash flow is necessary for a company to remain viable.

It is difficult to determine exactly what the underlying cause of a high or low current ratio is and where the cutoff is between a good current ratio and a bad one. Even though many accounting textbooks specifically indicate that a current ratio of 2.0 is a good benchmark to separate a favorable from an unfavorable liquidity position, this type of generalization is dangerous considering the differences among industries and the differences in working-capital management strategies among companies.

THE CASH CONVERSION CYCLE METHOD

Many of the disadvantages from using the static measures of liquidity can be remedied by using the CCC approach to analyzing liquidity. With this approach, company liquidity is measured using the equation in Exhibit 1.

The three-part formula in Exhibit 1 expresses the length of time that a company uses to sell inventory, collect receivables, and pay its accounts. Reconsidering FASB’s definition of liquidity, this formula, when compared to the current and quick ratios, better approximates assets’ and liabilities’ “nearness” to cash. The shorter the CCC, the more liquid the company’s working-capital position is.

The first part of the formula, days inventory outstanding (DIO), measures the number of days a company takes to convert its inventory into sales. An undesirable buildup of slow-moving inventory would result in a less favorable CCC. In contrast, the current ratio does not distinguish between liquid current assets and illiquid current assets. As far as the current ratio is concerned, inventories and cash are the same thing and are immediately available to take care of current liabilities.

The second part of the CCC formula, days receivables outstanding (DRO), measures the number of days a company takes to collect on sales. If a company relaxes its credit policies, and receivables become less liquid, the static measures of liquidity will not indicate this. As with slow-moving inventories, an undesirable buildup of accounts receivable will result in a less favorable CCC.

The third part of the formula, days payables outstanding (DPO), measures the number of days the company is able to defer payment of its accounts payable. With this portion of the formula, consideration is given to the length of time in which a company is able to obtain interest-free financing through credit relationships with vendors. The longer a company is able to delay payment (without harming vendor relations), the better the company’s working-capital position. Static measures of liquidity, however, punish the company for maintaining larger accounts payable balances, as illustrated in the earlier example.

A shorter CCC is favorable, and it is entirely possible to have a negative CCC. This would indicate that the company manages its working capital so well that it is, on average, able to purchase inventory, sell inventory, and collect the resulting receivable before the corresponding payable from the inventory purchase becomes due.

Dell Inc.’s business model allows it to maintain a very efficient CCC. In fact, the company has highlighted the CCC as a key performance metric in its financial statements. For the fourth quarters of fiscal years 2010, 2011, and 2012, Dell reported CCCs of ‒36, ‒33, and ‒36, respectively. Given the precise nature of the company’s working-capital management, it is able to support a somewhat lower current ratio (1.3 for the 2012 fiscal year).

Academic research concerning the CCC is somewhat limited, but one study by Hyun-Han Shin and Luc Soenen, “Efficiency of Working Capital Management and Corporate Profitability,” Financial Practice and Education, Vol. 8, No. 2 (1998), linked a favorable (shorter) CCC with increased corporate profitability and stock returns. As return on net operating assets (RNOA) is becoming a commonly used measure of firm profitability, it is also important to note that a reduction of the CCC involves a reduction of a company’s net operating assets, which will result in an increase in the company’s RNOA (see “A Better Way to Gauge Profitability,” JofA, Aug. 2008, page 38).

ILLUSTRATION: BEST BUY VS. CIRCUIT CITY

A comparison of Best Buy and Circuit City during the 10 years preceding Circuit City’s 2008 bankruptcy filing provides a good example of the additional information the CCC can provide. Exhibit 2 shows trends in the current ratios for the two companies, while Exhibit 3 shows CCC trends. The numbers were calculated from each company’s financial statements filed with the SEC.

Circuit City’s average current ratio during that time was 2.08, while Best Buy’s was 1.24. Although Circuit City experienced a downward trend after 2004, the company never reported a current ratio lower than that reported by Best Buy. An analysis of each company’s quick ratios revealed the same results. These static measures would indicate that Circuit City consistently had a better liquidity position than Best Buy.

During the same period, Best Buy’s average CCC, however, was five days, while Circuit City’s was 35 days (see Exhibit 3). This summary measure provides important information about the working-capital management of each company, but a deeper analysis of each of the three measures that make up the CCC reveals even more.

Best Buy’s average DIO was 18 days shorter than Circuit City’s, and Best Buy’s DRO was eight days shorter. Additionally, Best Buy was able to delay payment to vendors four days longer than Circuit City, thereby taking advantage of interest-free financing of working capital for a longer time.

The CCC analysis reveals that Circuit City’s “superior” current ratio was made up of slower-moving inventories, receivables with a longer collection time, and a smaller payables balance resulting from the shorter interval in which the company paid amounts owed. This analysis makes the current ratio seem somewhat irrelevant for analyzing liquidity.

Continuing with the example, Best Buy, which has been struggling to compete with online retailers such as Amazon.com, plans to close 50 large stores and open 100 smaller stores in fiscal 2013. Exhibit 3 shows a lengthening of Best Buy’s CCC in the years following 2003. For fiscal year 2012, the company’s CCC was 23 days, a number that has steadily increased in each of the previous nine years. A closer examination of the components of the CCC reveals that, although Best Buy’s DPO has essentially remained the same for several years, its DIO has increased by nine days since 2004, and its DRO has increased by 12 days. The company’s current ratio of 1.16, however, remains fairly close to the average current ratio of 1.24 that was discussed earlier. Incidentally, the CCC calculated from Amazon.com’s comparable financial statements was ‒38 days. Amazon.com’s current ratio, however, was 1.17, practically identical to Best Buy’s.

In analyzing a company’s liquidity, the CCC model succeeds where static measures of liquidity fail. While static measures of liquidity have weaknesses that are addressed by an examination of the CCC, the CCC also has limitations that are addressed by an analysis of the static measures. A limitation of the CCC is that it does not consider current liabilities such as interest, payroll, and taxes, which may also have a significant impact on liquidity. An advantage of the static measures is that they consider all current liabilities. With each measure of liquidity addressing weaknesses in the other measure, an examination of both the static measures and the CCC will lead to a much more thorough analysis of company liquidity.

With its link to a company’s profitability and stock returns, the CCC is a powerful tool for examining many aspects of how a company is being managed over time and in comparison with others within the same industry. Despite this, the CCC approach has been almost completely ignored by accounting textbooks, and many professionals seem to be unfamiliar with the approach. Investors, creditors, vendors, and accounting professionals must understand how a company’s working capital is being managed, and familiarity with the CCC is vital to gaining that understanding.

EXECUTIVE SUMMARY

The current ratio and its variations are most commonly used to assess a company’s liquidity, but these measures do not incorporate the element of time. Adding the cash conversion cycle (CCC) to those traditional measures leads to a more thorough analysis of a company’s liquidity position.

Static measures of liquidity are fairly simple to compute, but they can be quite difficult to interpret.

The CCC is calculated with a three-part formula that expresses the time that a company takes to sell inventory, collect receivables, and pay its accounts.

Comparing the current ratios and the CCCs for Best Buy and Circuit City during the 10 years before Circuit City’s 2008 bankruptcy filing illustrates the additional information that adding the CCC method can provide.

Corey S. Cagle (ccagle1@una.edu), Sharon N. Campbell (sncampbell@una.edu), and Keith T. Jones (kjones5@una.edu) teach accounting in the University of North Alabama’s Department of Accounting and Business Law.

To comment on this article or to suggest an idea for another article, contact Sabine Vollmer, senior editor, at svollmer@aicpa.org or 919-402-2304.

AICPA RESOURCES

JofA articles

• “The Missing Piece in Liquidity Calculations,” April 2012, page 34
• “A Better Way to Gauge Profitability,” Aug. 2008, page 38

Publications

How to Analyse Profitability: DuPont System, EBITDA and Earnings Quality

CPE self-study

• AICPA’s Controllership: 25 Critical Lessons From the Trenches (#741275)
• Auditing Considerations in an Uncertain Economy (#153410, on-demand one-year access; and #739630HS, CD-ROM)
• Financial Statement Analysis: Basis for Management Advice (#731254)
• Going Concern and Assessing Risk (#153400, on-demand one-year access)

For more information or to make a purchase, go to cpa2biz.com or call the Institute at 888-777-7077.