Question

Assume that you are a newly hired treasury analyst that is tasked with improving the liquidity position and overall financial management of Firm Y. Firm Y was incorporated 10 years ago and operates in the manufacturing industry. To begin your new position, you have been tasked with benchmarking Firm Y’s liquidity position. In terms of the key performance indicators to benchmark, your treasurer states that the “Current and quick ratios provide the best measures of our firm’s overall state of liquidity. In general, higher values for both indicate that our firm is more liquid. In fact, our recent current and quick ratios have been lower than our industry peers, so we need to increase them.”

Based on your understanding of liquidity management, you note that the cash conversion cycle and its components are critical. For this reason you have collected the information that appears in Table 2 (for your firm (Firm Y), Firm A (the market leader in the manufacturing industry), and the industry average for all manufacturers. In terms of the comparison reference groups, a two-way comparison will be utilized: Firm Y against Firm A and Firm Y against the industry average.

Table 2

	DSO	DIO	DPO	CCC
Firm Y	95	40	30	105
Firm A	59	15	35	39
Industry Average	90	50	30	110

, Part A: Assess the treasurer’s statement on using the current and quick ratios to evaluate firm liquidity. Do you agree or disagree and why?

                                                                                                

Part B: Evaluate and comment on Firm Y’s liquidity position based on the given metrics relative to those for Firm A and the Industry Average.

Answer 1

A]

Agree - current and quick ratios can give a snapshot of the overall liquidity position.Although there are other liquidity ratios such as interest coverage ratio, cash ratio, etc., current ratio and quick ratio provide the best overall picture. Both ratios have assets in the numerator and liabilities in the denominator. Hence, higher ratios indicate higher liquidity, or more assets for each unit of liabilities.

B]

Firm Y's DSO (days sales outstanding) is slightly worse than the industry average, and substantially worse than Firm A. It means that Firm Y takes much longer than Firm A to convert its receivables into cash.

Firm Y's DIO (days inventory outstanding) is slightly better than the industry average, but substantially worse than Firm A. Firm Y has its inventory locked up in working capital for 40 days before it gets converted into cash, whereas Firm A does it in 15 days

DPO is more or less the same for Firm A, Firm Y, and the industry

The CCC of Firm Y (105 days) is slightly better than the industry average, but the CCC of Firm A is very short at only 39 days.