Category: Credit Rating Methodologies

Liquidity analysis of a company [Part 2]

In the first part (Part 1) we discovered how to calculate the two following indexes Current ratio and Quick ratio and how to interpret them. But are these two indicators sufficient to see if a company has good liquidity? Absolutely not. During the operations of an enterprise, cash conversion cycles arise due to the time lag between payment collections from customers and payment of suppliers. In this cycle, there must be a balance in other words; if my clients do not pay me I find myself not having sufficient liquidity to pay my suppliers. What happens if the problem persists? Those suppliers do not supply me more and I close my company!

So what? So I have to go and check the Cash Conversion Cycle and values ​​of all its components:

Cash Conversion Cycle = DIO + DSO – DPO or

Cash Conversion Cycle = Days inventory outstanding +Days sales outstanding – Days payable outstanding .

You do not know how to calculate them? The easiest way (though it is not 100% correct) is as follows:

– DIO = (Inventories) / (Operating value) * 365

– DSO ​​= (Accounts receivable) / (Operating value) * 365

– DPO = (Accounts payable) / (Operating value) * 365

What is the optimal value of a Cash Conversion Cycle ? Hard to say, because:

1. Depends on the sector (for a bar, for example, the cash conversion cycle must be negative since the bar has to collect before it pays its suppliers);

2. For the calculation of the optimal value of the cash conversion cycle, thousands of observations should be taken into account.

modeFinance, thanks to its continuous analysis of all financial statements of companies all around the world, is able to understand what is the optimal value for each sector, the Cash Conversion Cycle and its components. And that is why it is able to detect imbalances in liquidity, even when the values ​​of Current and Quick ratio are ”normal”.

Look at this example with the case of Laboratoires SVR (SIRET: 61708009800057, modeFinance report here), a French company that is operating in cosmetics industry with a “procedure de sauvegarde” (insolvency proceedings) underway since December 2012. If we look at “classical” liquidity performance of this company we note that Current and Quick ratio are absolutely in line :

The data is obtained by analyzing 2012 financial statements of a group of companies operating in the ” NACE 20.42 – Manufacture of perfumes and toilet preparations ”

According to this information can we say it is balanced? No! In fact, continuing to observe the components in the Cash Conversion cycle you discover that the company has struggled to collect claims (it takes about 3 months longer than the industry average) and consequently to pay its suppliers (it pays with a delay of about one month and half or two months):

This (and other elements of course) has led modeFinance SRL to assign a MORE Rating class of CCC based on analysis of 2012 financial statements. Solution can be sought in combining solutions depending on the customer’s profile (budget, age, gender,interest, ... etc) and have a portfolio of both online services and offline services which are provided by “real” people.

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