Understanding Liquidity Assessment for Credit Risk- PART 1 (Current Ratio)

Liquidity is possibly one of the first thing we learn in credit risk assessment. In my financial analysis workshops, ‘What is liquidity?’ is possibly the easiest question and 99% of the participants answer as below

• It means how current assets (short term inflows) cover current liabilities (short term outflows)

• It is measured through Current Ratio (CR)

The answer it right, but only partially so. If you are assessing liquidity for credit risk evaluation, there are two important perspectives to be kept in mind. We address the first one in this article.

All Current is not Current

The first thing to note is that 4 broad categories of Current Assets (CA) have varying levels of liquidity and as a thumb rule follow this order:

Cash > Debtors > Inventory>Other Current Assets (OCA)

Clearly, Cash is the king, and 180-day inventory holding is not same as 30-day debtors. OCAs on the other hand may be a black box and as a rule should be of low materiality (value)and conservatively considered to be least liquid.

All this may sound fairly intuitive, however few analysts look deep enough into the nature of current assets pool. Most, if not all, rely on the CR calculated by excel.
Without differentiating liquidity grading of Debtors, Inventory and OCA, our inference on liquidity will be incorrect.

Current Ratio is a powerful tool but has its limitations. By aggregating all Current Assets, it inherently treats them equally. This may lead to a flawed interpretation of liquidity in many cases.

Let’s understand this with an example

Primetech Heavy Engineering is a manufacturer of custom build machines and assemblies. They undertake large value projects and the average lead time is 6 months to manufacture and supply the machines. The machines require hundreds of components, including some high-end electronics and sensors. These are sourced from around the world. Owing to lead time and varied sourcing, the average inventory holding is extremely high.

Current ratio in this case is likely to be picture-perfect but does it present the right view of liquidity? Not necessarily. A better way to measure liquidity in such a case is by excluding inventory. In other words, we are better off using Quick Ratio or Acid Test (CA-Inventory)/CL

For correct Credit Risk inference, the numerator (Current Assets) needs to be adjusted based on the real inflow possibility (liquidity grading). If an analyst relies only on the financial statement classification given by the Auditors, the inference may be incorrect.

A question that some may have : Why is Current Ratio so popular, then?

For the same reason we consider average business cycle to be 90 days to be comfortable heuristics (eg. Turnover Method)! The portfolios of most of the Indian lenders have Trading customer bias. Trading businesses, in turn, have low margins and practices, making long inventory or debtor days an unviable option. This means 30-60 cycle for either makes them similar in liquidity grading and hence Current Ratio fits well in many cases, without the need to fine-tune.

However, as one deals with varied and new industries, especially in manufacturing and services, the basket of CA/CL will need to be unpacked.

In short, not all fruits in the current asset basket are apples. Beware of the oranges and some rotting bananas.

Continue to Part 2: Understanding Liquidity Assessment for Credit Risk – PART 2 (NWC)