To help you to understand liquidity ratios, it is useful to obtain with a brief explanation of the cash cycle. The cash cycle describes the flow of cash out of a business and back into it again as a result of normal trading operations.
Cash goes out to pay for supplies, wages and salaries and other expenses, although payments can be delayed by taking some credit. A business might hold stock for a while and then sell it. Cash will come back into the business fro the sales, although customers might delay payment by themselves taking some credit.
The main points about the cash cycle are as follows.
- The timing of cash flows in and out of a business does not coincide with the time when sales and costs of sales occur. Cash flows out can be postponed by taking credit. Cash flows in can be delayed by having debtors.
- The time between making a purchase and making a sale also affects cash flows. If stocks are held for a long time, the delay between the cash payment for stocks and cash receipts from selling them will also be a long one.
- Holding stocks and having debtors can therefore be seen as two reasons why cash receipts are delayed. Another way of saving this is that if a company invests in working capital, its cash position will show a corresponding decrease.
- Similarly, taking credit from creditors can be seen as a reason why cash payments are delayed. The company’s liquidity position will worsen when it has to pay the creditors, unless it can get more cash in from sales and debtors in the meantime.
The liquidity ratios and working capital ratios are used to test a company’s liquidity, length of cash cycle, and investment in working capital.