What is Liquidity Index?
Liquidity index is a financial ratio that measures the ability of a company to convert its current assets into cash quickly. It is calculated by dividing the sum of the days required to liquidate trade receivables and inventory by the total value of trade receivables and inventory. A higher liquidity index means that the company has more liquid assets and can pay its current liabilities faster. A lower liquidity index means that the company has less liquid assets and may face cash flow problems.
How to Calculate Liquidity Index?
The formula for liquidity index is:
To calculate liquidity index in excel, you need to have the following data:
- Trade receivables: The amount of money owed by customers for goods or services sold on credit.
- Days to liquidate receivables: The average number of days it takes to collect the trade receivables from customers.
- Inventory: The value of goods or materials that are held for sale or use in production.
- Days to liquidate inventory: The average number of days it takes to sell the inventory and collect the resulting receivables.
You can use the following steps to calculate liquidity index in excel:
- Enter the data in a worksheet, such as:
| Trade Receivables | Days to Liquidate Receivables | Inventory | Days to Liquidate Inventory |
|---|---|---|---|
| 400,000 | 50 | 650,000 | 140 |
- In an empty cell, enter the formula for liquidity index, such as:
=((B2*C2)+(D2*E2))/(B2+D2)
- Press Enter to get the result, such as:
| Trade Receivables | Days to Liquidate Receivables | Inventory | Days to Liquidate Inventory | Liquidity Index |
|---|---|---|---|---|
| 400,000 | 50 | 650,000 | 140 | 106 |
How to Interpret Liquidity Index?
Liquidity index shows how many days it takes to convert the current assets into cash. A lower liquidity index means that the company can generate cash faster and has more liquidity. A higher liquidity index means that the company takes longer to generate cash and has less liquidity.
For example, if the liquidity index is 106, it means that it takes 106 days to convert the current assets into cash. This indicates that the company has a low liquidity and may face difficulties in meeting its short-term obligations.
A general rule of thumb is that a liquidity index of less than 90 is considered good, while a liquidity index of more than 120 is considered poor. However, the optimal liquidity index may vary depending on the industry, the business cycle, and the company’s strategy.
How to Improve Liquidity Index?
There are several ways to improve liquidity index, such as:
- Reducing the trade receivables by offering discounts for early payments, enforcing strict credit policies, and collecting overdue accounts.
- Reducing the inventory by managing the inventory levels, avoiding overstocking, and selling obsolete or slow-moving items.
- Increasing the sales by expanding the market, improving the product quality, and enhancing the customer service.
Example of Liquidity Index
Let’s assume that ABC Company has the following data:
| Trade Receivables | Days to Liquidate Receivables | Inventory | Days to Liquidate Inventory |
|---|---|---|---|
| 500,000 | 60 | 800,000 | 100 |
Using the formula, we can calculate the liquidity index as:
This means that it takes 86 days to convert the current assets into cash. This indicates that ABC Company has a high liquidity and can pay its current liabilities easily.
Other Approaches to Measure Liquidity
Liquidity index is not the only way to measure liquidity. There are other ratios that can be used to assess the liquidity of a company, such as:
- Current ratio: The ratio of current assets to current liabilities. It shows the ability of a company to pay its current liabilities with its current assets. A current ratio of more than 1 is considered good, while a current ratio of less than 1 is considered bad.
- Quick ratio: The ratio of current assets minus inventory to current liabilities. It shows the ability of a company to pay its current liabilities with its most liquid assets. A quick ratio of more than 1 is considered good, while a quick ratio of less than 1 is considered bad.
- Cash ratio: The ratio of cash and cash equivalents to current liabilities. It shows the ability of a company to pay its current liabilities with its cash. A cash ratio of more than 1 is considered good, while a cash ratio of less than 1 is considered bad.
- Defensive interval ratio: The ratio of cash, marketable securities, and accounts receivable to daily operating expenses. It shows the number of days that a company can operate without relying on external financing. A higher defensive interval ratio means that the company has more liquidity and can withstand financial shocks.
These ratios can be calculated in excel using similar steps as liquidity index. However, they may have different advantages and limitations depending on the nature and purpose of the analysis. Therefore, it is advisable to use a combination of ratios to get a comprehensive picture of the liquidity of a company.
