Liquidity Analysis Part 1: Net Working Capital

The term liquidity can be interpreted in various ways, depending of course upon the specific circumstances. In corporate financial accounting, liquidity refers to the firm's ability to pay its debts when they are due. The importance of possessing that ability should be self evident, as should the ability to evaluate a firm's liquidity position.

The first measure that you should be able to calculate is Net Working Capital:

Net Working Capital = Current Assets - Current Liabilities
Intel's 2008 Net Working Capital = $19,871M - $7818M
= $12,053M

In order to properly grasp the concept of Net Working Capital, you should be familiar with the two balance sheet accounts used to calculate it; Current Assets and Current Liabilities. Current Assets are basically those assets which are not necessarily long term in nature. It includes cash and cash equivalents, accounts receivable, and inventory held by the firm for sale. You should know however, that items like prepaid rent and prepaid insurance for the next 12 months also fall under Current Assets. Current Liabilities are short term notes payable, accounts payable, and the portion of long term debt that is due within the year. That being said, it should be evident that the prepaid rent portion of Current Assets wouldn't satisfy the cash obligation portions of Current Liabilities. The point is, investors need to dig in a little bit to determine the actual quality of a firm's net working capital. Also, it can be instructive to compare a firm's changes in net working capital over time. The chart below serves that purpose for Intel Corporation (INTC):
From the chart above, I'm not sure whether any discernible trend can be declared. Most likely, Intel was making use of it's cash for investments/acquisitions from 2003-2006, thus lowering it's net working capital. Intel is not a highly leveraged corporation - relatively speaking - though, so I wouldn't be too concerned with these fluctuations. If however, we observed that net working capital was declining, and over the same period the firm's debt-to-equity ratio was rising, it might be wise to pause and examine just why this was occurring.

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Operating Cash Flow to Current Liabilities: The Self-Sufficiency Ratio

One of the most fundamental questions we can ask about a company is whether or not it is generating the cash necessary to service its debts. Furthermore, it's important to differentiate between cash generated from operations, and cash generated from financing activities (borrowing or stock issuance); once a company starts raising money for the sole purpose of meeting current debt obligations, we might as well just call it a Ponzi-scheme. To help make that determination, we'll use the Operating Cash Flow to Current Liabilities Ratio.

To calculate the ratio, first locate Net Cash Flow From Operating Activities (CFFO); its found on the statement of cash flows.Next, go to the balance sheet and locate Current Liabilities; this represents debt that matures in one year or less, accounts the company must pay within the year, and the current (one year or less) portion(s) of long term debt.You'll need to calculate the average amount of current liabilities for the period you're examining. Therefore, because the balance sheet represents only a single point in time, you'll need to average the current liabilities section from the two separate balance sheets which mark the beginning and end of the period for which you want to perform the analysis.Divide CFFO by the average current liabilities, and there you have the ratio. Any result less than 1 indicates that the company is not able to liquidate its current liabilities from operating cash flow; in other words, the company will probably have to sell assets, borrow money or issue stock in order to meet its short term debt obligations. (Hence, the "self-sufficiency" title to this post).The 2008-2009 solution is, of course, to conduct a mass layoff. Nothing frees up cash quicker than handing out 10,000 or so pink slips.

One company whose CFFO to Current Liabilities ratio I was particularly impressed with is Intel (INTC). I'll run through the calculation using Intel's numbers below:

Operating Cash Flow to Current Liabilities = Net Cash Flow From Operations / Average Current Liabilities

=$10,926M / ( ($7818M + $8571M) /2)
=$10,926M / $8194.5M
=1.33

As you can see, Intel's ratio of 1.33 stacks up quite favorably against the other companies in the chart below:

Obviously, despite Wal-Mart's poor looking ratio of 0.4, there is no reasonable chance that it won't be able to pay its bills. I imagine that, being the largest employer in America, Wal-Marts wages payable account grows by hundreds of millions of dollars every week. In fact, accounts payable represented around 70% of Wal-Mart's short term debt. As is always the case, this ratio is not a silver bullet, and needs to be used in conjunction with other tools. Sphere: Related Content