Drags and Pulls on Liquidity

What are the Drags and Pulls on Liquidity?

Drag on liquidity is the collection of cash inflows to the company or the rate by which the company collects receipts.

Meanwhile, pulls on liquidity are defined as cash outflows or decisions that result in faster/slower disbursements. It also relates to limited access to credit.

Knowing the drags and pulls on liquidity for a company is extremely important for the business as the firm will need to understand its weaknesses. 

If the drag on liquidity is high, the company will need help to collect payments due to it. This means that the firm might find it difficult to repay its suppliers, employees, and creditors as receipts take such a significant time to recover that it might not be able to pay these creditors in time.

If pulls on liquidity are high, the cash outflow is very quick. Hence, companies might end up focusing on only repaying their most important liabilities and might not have sufficient time to use the capital to reinvest in other beneficial areas.

When access to credit is limited, for instance, if banks are hesitant to lend due to widespread hawkish sentiment, companies could all face pulls on liquidity. This is exacerbated if the company also sees a high cash outflow rate. 

Primary and Secondary Sources of Liquidity

Primary sources of liquidity mean either cash or near-cash assets. Firms do not usually require this form of liquidity for the company's day-to-day functions. This includes short-term T-bills or commercial paper in a company's financial statement.

These resources are the easiest method a company can turn to for repayment of loans and may increase pulls on liquidity if the company is in a tight bind.

Secondary sources of liquidity refer to resources that cannot be converted to cash as easily. These are usually assets that are important in the company's operations.

Assigning primary and secondary sources of liquidity to current assets held is important because these areas are important in identifying how to pull on liquidity that could potentially affect the company.

For instance, if a company needs to repay its creditors urgently before a certain date, which could potentially affect the manner of loans creditors would be willing to loan in the future, then primary liquidity would best help increase pull on liquidity.

A secondary source of liquidity would not help increase the pull on liquidity as it takes a long conversion time to liquefy. Therefore, only when primary sources of liquidity are fully exhausted should secondary sources be used. 

Pull-on liquidity would be much reduced when using these assets for sale due to the long time required for conversion into cash and disbursements.

An example of this would be the storied tale of Toys' R' Us in 2017. This company used to be one of the market leaders for retail juvenile demographic toys.

In 2020, Hertz, the car rental company, filed for Chapter 11. Because of the COVID-19 crisis, Hertz suffered a great amount of loss in business due to people not traveling and, as a result, not renting its cars.

Because of people staying at home, Hertz also attributed the slow-down in car rentals to how people could not leave the house and, therefore, the chances of car accidents (and renting its cars in the meantime) are lowered.

Hertz also had its fleet of rental cars as waged as collateral. Hence, when the value of these cars was reduced, Hertz displayed negative equity due to its assets being worth less than its debts. 

Hertz also suffered from a pull in liquidity as the fall in the value of pledged collateral would harm its credit score with the bank, making it unable to draw any money from lenders. As a result, it subsequently went into Chapter 11.

Days sales outstanding (DSO)

Days sales outstanding reflects how many days a company takes to collect payments after it issues an invoice to the counterparty. More specifically, cash is deposited in the company's account days after the invoice is issued. 

The formula to calculate DSO is, therefore:

Where,

• Accounts receivable: Balance of money due to a firm that has yet to be paid after issuing services/goods to its clients and the invoice sent. Average accounts receivable take into account the daily accounts receivable per day.
• Total credit sales: Money generated from the sales of goods/services minus the amount of cash already received. (sales - cash)
• 365/366 days are used depending on whether the year is a leap year. 

Finding the accounts receivable divided by credit sales allows us to identify the percentage of the amount owed to the company against the amount that has yet to be received.

A high DSO would indicate waiting a long time before collecting receipts. Low DSO would show that receipts collection is fast. Of course, all this is relative to comparable companies in the industry.

DSO is important as we can calculate how efficiently the company collects receipts through DSO. This is linked to drag on liquidity. One can then say that a high DSO would relate to stronger drags on liquidity, and a low DSO would relate to weaker drags on liquidity.

For instance, a decrease in credit sales and the same amount of accounts receivables would increase DSO but might not indicate inefficiency from the collection department. 

Rather it could mean that past account receivables sold by the company are returning well, but the company sold fewer products this year.

Days payable outstanding (DPO)

Days payable outstanding correlate to how many days a company takes to outflow disbursements for goods and services obtained on credit. It measures the days the company takes to repay its debt to trade creditors.

The formula to calculate DPO is as follows:

where,

• Accounts payable: A company's short-term debt to suppliers that it has yet to pay
• Cost of goods sold: Cumulative amount of cost required for the production through to the sale of the good

Products would often require cost in their generation. For example, in primary sectors, coal mining (a raw material) would have costs involved in being able to source for a mining site, recruit workers to work in mines, and purchase the equipment required to mine the coal, just to name a few.

Likewise, secondary sectors (process materials) would also have costs involved in their manufacturing. Products such as mobile handhelds have many small electronic components that have to be sourced for and pieced together. 

High DPO would correlate to the company having more cash to invest in short-term investments. This is a decrease in the pull of liquidity and is generally seen as a good thing as the company could have longer credit terms, improving its cash position.

However, high DPO could also correlate to needing help paying its debts duly. If the company needs to work on gathering sufficient cash to pay its fees, it might lose out on any discounts for early payment, along with the relationship with its suppliers.

Low DPO might not necessarily be good, either. For example, suppose companies should be repaying their debts slowly. However, it might reflect a positive development on the end of being able to repay financial bills quickly and on time. In that case, it is not fully using the window accorded by their debtors.

For instance, with a wide repayment window, the company could reinvest its cash into short-term investments to generate more capital. However, if it instead chooses to disburse cash quickly, pull on liquidity would be lower, and beneficial results of reinvestment would not apply.

Cash conversion cycle (CCC)

The cash conversion cycle is the total number of days it takes for the company to convert the cash required for inventory into selling the product. It takes into account both drags and pulls on liquidity. The formula as shown:

Cash Conversion Cycle(CCC) = Days inventory outstanding + DSO - DPO

By factoring in drag on liquidity (DSO) and pull on liquidity (DPO), the cash conversion cycle measures how holistic the company generates cash and its liquidity.

Ultimately, the CCC considers its inventory management, sales realization, and payables essential in tracking how the company can manage key business matrixes.

A lower CCC is usually seen as better than comparable companies. This is because a lower CCC indicates fewer days required to convert inventory into cash, and the faster the cash generation, the more cash it can be used to restart the cyclical process.

CCC can also be negative, especially in the case of online retailers. Online retailers often receive funds in their accounts immediately after the transactions between sellers and buyers on their platform. Acting as an intermediary, it will receive the cash amount first.

However, online retailers only disburse the cash on a stipulated basis, such as monthly or threshold-based. Hence, it would have a negative DPO, resulting in high CCC.

Working capital

Working capital examines the company's resources to cover its short-term debt. If working capital is negative, it is indicative that there is more short-term debt than assets. 

This liquidity matrix examines whether and how much excess cash (or the lack thereof) the company has to repay its day-to-day dealings should it require cash. If cash flow is managed effectively, it will help the company avoid financial trouble.

Working capital = Current assets - current liabilities

• Current assets: Cash converted readily from assets for day-to-day operations.
• Current liabilities: Obligations due in the short term must be repaid.

Please repay liabilities by their maturity to avoid damage to the reputation of the company (weakening investor confidence) and would prevent the company from reinvestment opportunities since all its current assets are caught in paying off liabilities.

Current assets and liabilities must be converted within a year (12 months) and are the company's barometer to measure the short-term. Working capital is often used with liquidity ratios, as they best access the company's liquidity in the short run.

Current ratio

The current ratio is a widely used financial ratio that measures a company's ability to meet its short-term financial obligations. It is calculated by dividing a company's assets by its liabilities. 

The resulting result represents the current assets available to cover each dollar of current liabilities.

The current ratio measures how quickly the company can convert its current assets to cover its current liabilities. If the value exceeds 1, the company can fully convert its current assets to cover its current liabilities.

If the value is less than 1, the company is at risk of not being able to have current assets cover current liabilities, which puts the company at risk of default and lowers investors' confidence that the company has healthy financials.

Quick ratio

The quick ratio, also known as the acid-test ratio, is a financial ratio that measures a company's ability to meet its short-term financial obligations using its most liquid assets. It is calculated by dividing a company's quick assets by its current liabilities.

The quick ratio matrix measures the most important and easily convertible assets that can be used to cover its current liabilities. This comes in cash, cash equivalents, current receivables, and short-term investments.

This acid test measures assets that can be converted more quickly and efficiently into cash to cover current liabilities and only uses cash-convertible assets in 90 days.

Both ratios are used with working capital to find more useful information about the company.

We can see the extent to which short-term assets cover their short-term liabilities and the exact numerical quantity for this allowance through working capital.

If working capital is $1,000,000, it shows the company the leeway to continue adding current liabilities without letting current liabilities offset current assets.

The current ratio approximates how assets cover $1 worth of current liabilities. If the current ratio is 5.5, $5.50 of current assets covers $1 of current liabilities and helps the company assess how much current liabilities it can take.

Lastly, the quick ratio shows how much cash and its short-term equivalents can cover $1 of current liabilities. Since the quick ratio is only taking into account quick assets, the company meets situations where it needs to convert its assets as fast as possible.

While the working capital and current ratio usually correlate, with the current ratio showing specifics of how much current liabilities it can take on with its current assets, the quick ratio might sometimes not correlate as it only considers quick assets.

Drags And Pulls On Liquidity Conclusion

In conclusion, understanding the concept of drag and pulls on liquidity is crucial for companies as it affects their ability to access funding and pay their debts on time.

A drag on liquidity in the broader financial markets can make it more difficult and expensive for companies to raise capital. Pulling on liquidity at the company level can lead to early payments or a reduction in trade credit. 

This may force companies to sell assets or seek financing options that could negatively impact their financial stability in the long run. Therefore, companies must monitor their liquidity position using various financial ratios such as working capital, current ratio, and quick ratio. 

By doing so, companies can identify potential liquidity issues and take appropriate actions to address them before they become serious problems. 

This is all-important in being able to measure the liquidity of a company. Particularly, current assets relate to how well the company's position concerning drag on liability is, and current liabilities relate likewise to the pull on liquidity. 

Drag and pull on liquidity helps identify which assets will have receipts credited to them quickly or which liabilities will require disbursements quickly. All the concepts relate deeply to liquidity requirements for the company.

Researched and Authored by Jo Vial | LinkedIn

Reviewed and Edited by Raghav Dharmarajan

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