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Liquidity Index
Description: The liquidity index measures the number of days it would take to convert accounts receivable and inventory into cash. This is useful for determining a company’s ability to generate sufficient cash to meet upcoming liabilities.
Formula: Multiply the accounts receivable balance by the average number of days required to liquidate it. Then multiply the inventory balance by the average number of days required to liquidate it (which includes both the number of days to sell the inventory and the number of days to collect the resulting accounts receivable). Then add these two items together and divide them by the sum of all accounts receivable and inventory. If the accounts receivable or inventory balances tend to fluctuate significantly, an average figure can be used for both. The formula is as follows:
(Accounts Receivable x Days to Liquidate) + (Inventory x Days to Liquidate)
Accounts Receivable + Inventory
Example: The Doughboy Donut Company’s president wants to determine the company’s ability to convert its short-term assets into cash, and decides to use the liquidity index to provide this information. He is informed by the controller that the company has $382,000 of accounts receivable, which typically require 47 days to liquidate. The company also has $712,000 of inventory, which turns over six times per year. With this information, he calculates the liquidity index as follows:
(Accounts Receivable x Days to Liquidate) + (Inventory x Days to Liquidate)
Accounts Receivable + Inventory
=
($382,000 Receivables x 47 Days to Liquidate) + ($712,000 Inventory x 107 Days to Liquidate)
$382,000 Receivables + $712,000 Inventory
= 86 Days to Convert Accounts Receivable and Inventory into Cash
Note that the number of days to liquidate the inventory is not just 60 days, as would be indicated by the six inventory turns per year, but rather 107 days, which includes the additional 47 days to collect the accounts receivable into which the inventory will be converted once it is sold. Because of the preponderance of inventory in this computation, which requires extra time to liquidate, the liquidity index is a lengthy 86 days.
Cautions: The chief difficulty with the liquidity index is that it is based on average collection periods, and so does not yield a great deal of precision in regard to the exact amount of cash that will be available on a certain day. For example, if a company tends to collection the bulk of its cash on a specific date (perhaps from a single large customer), real cash flows will be largely based on the arrival of that single payment, despite the average cash flow figure revealed by the liquidity index.
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