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Review questions

Lack of liquidity can among other things:

  • Limit management's freedom of action
  • Reduce the potential for profitable investment opportunities
  • Force managers to divest profitable businesses with a substantial discount
  • Increase financial expenses
  • Lead to suspension of payment and possible bankruptcy

The first question to ask when assessing the liquidity risk is if the firm has a sound financing structure. With that we mean if there is a good balance between equity and long-term and short-term financing, corresponding to the nature of the assets and the risk of operations.

When the financing structure is in place the next question is if the firm on an ongoing basis has sufficient cash flows to pay interest and instalments. A related issue to the ability to meet future obligations is whether a firm has liquidity reserves for rainy days; i.e. events that have significant impact on the cash outflows. Finally, is the firm liquidity efficient; i.e. is the firm utilising its spending on working capital and other related assets in an efficient manner?

In summary:

  • Does the firm have a sound financing structure?
  • Is cash from operations sufficient to pay debt on an ongoing basis?
  • Are there liquidity reserves for a rainy day?
  • Is the firm liquidity efficient?
  • Equity ratio
  • Financial leverage
  • Risk tolerance equity ratio
  • Buffer equity ratio
  • Modified risk tolerance loss ratio
  • Long-term financing coverage ratio
  • Interest coverage ratio
  • Cash flow from operations to debt ratio
  • Debt to EBITDA ratio
  • Capital expenditure ratio
  • Liquidity reserve ratio
  • Working capital ratio
  • Liquidity cycle
  • Current ratio and quick ratio
  • Cash flow from operations (CFO) to short-term debt ratio
  • Cash burn rate
  • Liquidity current reserve ratio

Financial ratios measuring liquidity risk are

  • Based on historical accounting information and, therefore, backward-looking
  • Only describing parts of a firm’s financial position
  • Less useful in the absence of an appropriate benchmark
  • Less useful if they are not used together
  • Sensitive to accounting estimates and choice of accounting policies
  • Does not distinct between recurring and non-recurring items

Perform a comprehensive analysis that uncovers all important aspects of a firm’s financial position. In addition to the financial analysis outlined in this chapter, it should include a strategic analysis which encompasses an assessment of the industry attractiveness and the competitive edge of the firm being analysed relative to its peers. Ideally, the financial analysis and the strategic analysis should be merged into a quantitative assessment of the future cash flow potential of the firm.