The liquidity index calculates the days required to convert a company's trade receivables and inventory into cash. The index is used to estimate the ability of a business to generate the cash needed to meet current liabilities. Use the following steps to calculate the liquidity index:
- Multiply the ending trade receivables balance by the average collection period.
- Multiply the ending inventory balance by the average inventory liquidation period. This includes the average days to sell inventory and to collect the resulting receivables.
- Summarize the first two items and divide by the total of all trade receivables and inventory.
The liquidity index formula is:
((Trade receivables x Days to liquidate) + (Inventory x Days to liquidate)) ÷
(Trade Receivables + Inventory)
The liquidation days information in the formula is based on historical averages, which may not translate well to the receivables and inventory currently on hand. Actual cash flows may vary substantially around the averages indicated by the formula. Also, if this information is plotted on a trend line, be sure to consistently apply the same averaging method to all periods; otherwise the results may be unreliable.
For example, Hassle Corporation's controller wants to understand the ability of the company to convert its receivables and inventory into cash. Hassle has $400,000 of trade receivables on hand, which can normally be converted to cash within 50 days. Hassle also has $650,000 of inventory, which can be liquidated in an average of 90 days. When combined with the receivable collection period, this means it takes 140 days to fully liquidate inventory and collect the proceeds. Based on this information, the liquidity index is:
(($400,000 Receivables x 50 Days to liquidate) + ($650,000 Inventory x 140 Days to liquidate)) ÷ ($400,000 Receivables + $650,000 Inventory)
= 106 Days to convert assets to cash
The larger proportion of inventory in this calculation tends to skew the number of days well past the liquidation days for trade receivables. In short, Hassle will require a lengthy period to convert several current assets to cash, which may impact its ability to pay bills in the short term.