If liquidity is a key metric to consider when looking for safer shares, what is the best measure of liquidity?

Financial websites tell us to focus on a combination of the Current Ratio and the Quick Ratio.ย  As you know, both have flaws relating to the time required to turn assets into available cash.

The Current Ratio tells us nothing about how long it takes a company to convert its inventory into cash.ย  The Quick Ratio is supposedly an improvement since it eliminates inventory from the equation, but it fails to consider how long it takes a company to convert its receivables into cash.

There is another metric called the Cash Conversion Cycle that in most cases is the best measure of liquidity available.ย  The Cash Conversion Cycle focuses on the time it takes a company to manage three business processes that determine the company’s ready access to cash:

1.ย ย  ย How long it takes to sell what you own; or DIO (Days Inventory Outstanding)
2.ย ย  ย How long it takes to collect what you are owed; or DSO (Days Sales Outstanding.)
3.ย ย  ย How long it takes to pay what you owe; or DPO (Days Payable Outstanding.)

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Considering the fact this metric is lauded by Economists as providing a truer picture of the real financial health of a company, it is somewhat surprising you will not find the Cash Conversion Cycle on any financial website.ย  This may be due to the fact the Cash Conversion Cycle is most applicable to retailers and manufacturers that maintain inventory.ย  Whatever the reason, it is a useful measure and here is the formula for calculating the Cash Conversion Cycle (CCC):

CCC = DIO + DSO – DPO

While it is relatively easy to calculate the three components of this formula from figures readily available in the company’s financial statements, you may find them already calculated in Financial Analyst Research Reports.ย  Some premium websites give you access to such reports for many Australian shares.ย  Some analysts use different terminology, such as Days in Inventory or Average Inventory Collection period; and Average Receivables and Payables Processing Period.

For now, let us see how to calculate the Cash Conversion Cycle for Australian retailing giant, Woolworths (WOW.)

Calculating the DIO

To determine DIO (Days Inventory Outstanding) you will need to know:

โขย ย  ย Average Inventory of the time period you are measuring.
โขย ย  ย Cost of Sales per day for the same time period.

To get the average inventory you need to add Woolworth’s beginning inventory and ending inventory for the period and divide by 2. Most analysts use year over year, but it would be possible to examine the CCC on a quarter-by-quarter basis.

From WOW’s Balance Sheet we see 2009 ending inventory of 3,292 (\$m), to which we add 2010 beginning inventory of 3,438 (\$m).ย  Dividing the result of 6,730 by 2 gives us an Average Inventory of 3,365.

From WOW”s Income Statement we see a cost of sales of 38,391 (\$m), which we divide by 365 to get a cost of sales per day figure of 105.

Finally, we divide average inventory of 3,365 by the cost of sales per day of 105 to determine that WOW’s DIO is 32.

Calculating the DSO

To calculate the next component of the CCC formula – DSO – we will need a net Sales per Day figure and an average Accounts Receivable figure for the year.

First we get Net Sales, or Revenue from the Sale of Goods, from the Income Statement – 51,694 (\$m) and divide it by 365 for a net Sales per Day figure of 142.

Second, from the Balance Sheet we add ending Accounts Receivables for 2009 (664 \$m) and beginning Receivables for 2010 (917 \$m) and divide the total (1,581 \$m) by two to get an average Accounts Receivable of 790.5.

Finally, we divide the average Receivables of 790.5 by the net Sales per Day of 142 to get a DSO of 5.5, or 6 rounded.

Calculating the DPO

To determine the DPO we already know the Cost of Sales per Day – 105 – so all we need is an average Accounts Payable for the year.ย  From the Balance Sheet we add ending Accounts Payable for 2009 of 5,110 to beginning Payables for 2010 of 5,279 and divide the total – 10389 – to get an average Accounts Payable for the period of 5195.

Finally, we divide the average Payables of 5195 by the Cost of Sales per Day of 105 to get a DPO of 49.

Calculating the CCC (Cash Conversion Cycle)

Plugging in the values we have for DIO, DSO, and DPO into the formula yields the following:

CCC = 32 (DIO) + 6 (DS0) – 49 (DPO) =-11

How can any company possibly have a negative Cash Conversion Cycle?ย  Does that not imply Woolworths converts its sales into available cash before the sale is made?

In actuality, it is possible for a company to have a negative CCC.ย  All it means is the company is paid from its direct customers before it has to pay its suppliers.ย  Although they have many business segments, Woolworth’s principal business is groceries, where inventory turns quickly and payment for goods sold is made at the moment of sale.

In effect, Woolworths gets paid right away for goods it waits an average of 49 days to pay for.ย  Obviously, Woolworths does not have liquidity issues.ย  Checking both their Current and Quick Ratios and you will see Woolworths performs far better on those metrics than other companies in its sector.ย  Their Current Ratio is .73 compared to 1.04 for its industry segment and its Quick Ratio is .20 compared to .47 for the segment.

In conclusion, there are may be other factors to consider before making a share purchase decision on WOW, depending on your investment strategies.ย  However, if financial health and liquidity are what you are looking for, Woolworths certainly merits a place on your watch list.