Business Liquidity Measurements Tools - dummies

Business liquidity measurements are meant to evaluate a business’s total liquidity by using both data as presented at a point in time, as well as resources available to a business (but not necessarily presented in the basic financial statements) either today or in the future. Following are liquidity measurement tools:

• Available current working capital: Takes the current net working capital of the company and adds available capital that can be accessed during the next 12 months. This figure then needs to be adjusted to account for any other factors, such as extended vendor terms that impact the company’s liquidity.

In the example below, two points should be noted. First, in 2012, the available borrowing capacity was reduced to account for \$1 million of obsolete inventory. In this example, the bank became concerned about the value of this inventory and decided to eliminate it from the company’s capability to borrow.

Second, in 2013, \$1.5 million was added back to account for the fact that the company was able to secure extended payment terms from vendors for the coming year. In effect, the company has secured a “permanent” source of capital for the year from the vendors providing extended terms (and thus providing more capital to operate the business).

• Cash burn rate: Calculates the average negative cash flow (defined as net income or loss plus depreciation expense) the company is experiencing on a periodic basis (usually monthly). Burn rates represent key data points for investors attempting to understand how long a company will take until it becomes cash flow positive. This figure then drives how much capital is needed to support the company during the negative cash burn periods.

For XYZ Wholesale, Inc., the company’s cash burn rate was approximately \$60,000 a month in 2013. The equation to calculate this would be to take the annual net loss of the company, add back depreciation expense, and then divide it by 12 to calculate the monthly burn rate.

• Liquidity availability analysis: The concept with this analysis is to calculate the potential available liquidity that can be tapped from company assets and compare it to the total current outstanding debt (secured with the assets). The idea is to evaluate whether any “untapped” sources of capital are available on the balance sheet. Below, roughly \$1.5 million of potential and actual liquidity is available (even though the solvency measurements paint a much more difficult situation).

Liquidity measurement tools.

The three liquidity measurement tools provided represent just a small sample of the entire list of potential liquidity measurements tools available. Unlike business solvency measurements, liquidity measurements tend to be customized for specific company and industry issues in order to properly manage and understand liquidity at any point in time. The key concept, however, remains the same because you must always have a clear understanding of what capital and liquidity is available to your company (at any time) in order to properly manage your business interests.