Measuring a company’s liquidity position becomes the work of liquidity ratios, a class of financial metrics which determine how well a company could repay debt obligations using its own working capital, without the need to acquire external funds.  

Generally, liquidity ratios illustrate the relationship between current assets, or certain portions of current assets, and current liabilities on the balance sheet. Some are more stringent than others, and each has its own standard for what signifies a healthy liquidity position. 

However, traditional liquidity measures often fall short in providing a comprehensive picture. This is where the Net Balance Position (NBP) developed by developed by Dr. Pricer from the School of Business at UW-Madison, proves to be significantly more effective.  

Commonly Used Liquidity Ratios  

There are three commonly used liquidity ratios; ranging from least to most stringent, you have the Current Ratio, Quick Ratio, and Cash Ratio.  

For all of these ratios, the higher the number, the healthier the liquidity position and margin of safety. Their principles vary, and in practice, it must be remembered that they range from less to more stringent.  

These ratios are explored below, along with their shortcomings, and why there is a need for a more innovative measure of cash liquidity. We are, after all, measuring liquidity to improve financial decisions. If you are working with suboptimal information, you may be apt to make suboptimal financial decisions.  

Current Ratio (Working Capital Ratio): most general, least stringent, measures a company’s ability to repay short-term debt using all of its current assets. A Current Ratio of 2 is considered safe, showing there is twice the amount of current assets to cover current liabilities. Generally, a range between 1.5 – 3 typically signifies a healthy liquidity position, with the higher result indicating a better liquidity position. As it relies on all current assets to cover liabilities, it does not account for how quickly those assets are converted into cash, like inventory, and could give an inappropriately optimistic view of liquidity position.  

Quick Ratio (Acid Test): more stringent than the Current Ratio, measures a company’s ability to repay short-term debt using only its most liquid assets, removing less-liquid assets from the equation, like inventory. A Quick Ratio of 1 or higher signifies a healthy liquidity position, while 2 is considered safer, indicating a 2:1 relationship between the liquid assets and the liabilities they’re intended to cover. The problem with the Quick Ratio, although more stringent than the Current Ratio, is that it considers accounts receivable as a liquid asset, regardless of how long it takes to collect receivables. Likewise, it does not consider inventories that are quickly converted into cash.  

Cash Ratio: most stringent of all the traditional liquidity ratios highlighted here, measures how well a company repays its short-term debt using cash and near-cash equivalents, or investments, while ignoring less liquid assets like accounts receivable and inventory. Simply, a Cash Ratio of 1 signifies there is an equal amount cash and near-cash equivalents to cover current liabilities, more signifies more, and less indicates insufficiencies. The unrealistic reality involving the Cash Ratio is that very few businesses have enough cash or near-cash equivalents to cover liabilities, making this ratio less realistically used. 

Improved Measure of Cash Liquidity 

To solve the shortcomings of traditional liquidity ratios, an innovative new measure was developed at the University of Wisconsin-Madison’s School of Business by a distinguished professor of entrepreneurial management, Dr. Robert Pricer.  

Stringent and far more reliable in uncovering a company’s liquidity risks, this new metric was termed the Net Balance Position (NBP).  

NBP Ratio: a comprehensive measure of a company’s liquidity risk, this metric considers Working Capital Available (WCA), dividing it by Working Capital Requirements (WCR). The stringency arises in the latter, holding as requirements all inventory and accounts receivable, rather than seeing these as offsets to liabilities. A NBP Ratio of 1 signifies an equal amount of WCA to adequately cover WCR, stringently illustrative of cash liquidity safety, while a ratio less than 1 shows inadequacies, and safe margins of surplus above 1.  

Imagine, a company has a healthy asset side of the balance sheet compared to the liabilities, likely with minimal cash on hand, while their accounts receivables and inventory accounts are large, offsetting liabilities in a way that are determined safe by traditional liquidity measures.  

However, this does not account for how long it takes to collect receivables, or turn inventory into cash, or otherwise convert near-cash equivalents into cash for debt management. In other words, a company may have a very healthy Current or Quick Ratio, but take 45-days to collect receivables and 90-days to flip inventory, yet with the slightest business or economic downturn, the company could quickly come into an unhealthy cash liquidity situation if customers can’t pay within their normal ranges or demand for a product decreases leaving unconverted inventory for longer than normal. 

NBP however, considers Working Capital Available and looks at accounts receivables and inventory to be accounted for, dollar-for-dollar as Working Capital Requirements, with a minimum amount of cash considered for a stringently safe Cash Liquidity position, more appropriately balanced, Net Balance Position (NBP).  

While traditional liquidity measures are more static, and inadequately assess the timing of cash inflows and outflows, NBP considers these more dynamic realities by accounting for the irregular nature of receivables and inventory.  

Automation of Net Balance Position 

Consider leveraging tools and software to automate NBP assessment. iCFO Pro is one such tool from a company co-founded by the originator of NBP and includes “what-if” scenario modeling to receivables or inventory, and even accounts payable adjustments, while illustrating impacts to NBP, and overall Cash Conversion Cycle. Other “what-if” modeling includes impacts to Return on Asset Investment (ROAI), and Sustainable Growth Rate (SGR), to complement NBP comprehensively.  

Call to Action: Discover the power of the Net Balance Position for your business. Visit www.icfo.pro to learn more about how this Software-as-a-Service (SaaS) automates this advanced measure, and how NBP can enhance your financial analysis and strategic decision-making for the most optimal financial and operational decisions. Explore our industry reports and tools and contact [email protected] to schedule a demo.