By Robin Currie
Liquidity measures make up a large part of what Currie Management Consultants, Inc. calls the Report Card for the Executive. One important function of the liquidity ratios is that they are used to assist dealer principals in measuring the ease with which their enterprise can repay its short-term and long-term debt obligations. This is done by comparing assets, or groups of assets, to liabilities, or groups of liabilities, all focused on the conversion to cash cycle. Three calculations are important to focus on for this process: debt to equity, current ratio and working capital turns.
Debt to equity is the global, universal measure most often used to evaluate the liquidity position of an enterprise. For distribution firms the traditional, and still relevant, debt to equity standard is, less than 3:1. It is calculated by dividing total liabilities by total net worth (the lower the number, the better). When a business is appropriately capitalized, there is excess equity and free cash.
Strong performance in debt to equity supports the consolidation process that is currently trending in all distribution industries. When debt to equity is strong, below 2:1, it is time to begin discussions about expansion or acquisitions. If the debt to equity is outstanding, below 1:1, your enterprise is in position to complete an acquisition immediately. Do not let your capital (equity) underperform — especially in low interest periods. Strong equity and low interest rates are consolidation drivers.
Current ratio, another liquidity measure, is normally viewed as a subset of debt to equity. Usually if debt to equity is quite strong, then current ratio results tend to be strong as well. The opposite is also true. Current ratio is calculated by dividing current assets by current liabilities. The standard for an industrial equipment dealer is, 1.75:1.Working capital turns is the measure that rounds out the Liquidity analysis. Measured through total annualized sales divided by working capital, it tells us how rapidly the working capital turns (works) and the resulting stress it places on cash flow. Generally, in distribution businesses a working capital turns result of between eight turns and 12 turns is the desired performance.
Working capital turns greater than 12 indicate insufficient working capital to meet the cash flow requirements of the sales volume. High working capital turns put unnecessary stress on rapid collections, and/ or cause firms to extend payments to suppliers. Working capital turns that are below eight turns indicate excess working capital which results in reduced needs to turn assets — because you have plenty of working capital. Low working capital turns firms generally are slow on billing, slow on collections, have high work in process, carry aged inventory, but pay their bills promptly.
In addition to the three measures already described, debt to equity ratio, current ratio and working capital turns; let’s now begin to examine the equity to sales ratio. The formula that is used in the computation of equity to sales is as follows: Average Net Worth (or Owner Equity Dollars) / Gross Sales Dollars
For distribution companies the standard is 10 percent. Less than 10 percent could indicate toolittle equity (capital); greater than 10 percent starts to identify excess capital, or, more appropriately, available capital.
For example, if a company has annual revenue of $30 million, and, the target equity to sales rate is 10 percent, than, the equity should be $3 million. If this firm actually has $6 million in capital, equity to sales of 20 percent, it may likely have $3 million in available capital. Of course, if this firm has excess receivables, excess work in process, inventories with birthdays, it might have tied up the extra $3 million of capital in poor performing assets. Many firms that come to us at the beginning of an acquisition or expansion worry that they don’t have enough capital. Often we advise them that they have enough capital, they just are not using it correctly. So, a cleanup of assets and appropriate restructuring of debt are the types of simple changes that free capital for expansion and acquisition.
The liquidity measures shown here are critical, straightforward measures of enterprise. This is why we use them to evaluate the executive, or the executive team. The results of these liquidity measurements, like all other benchmark performance measures in the Currie Financial Model, can lead us to ask penetrating questions, and yield a deeper understanding of the operations of an equipment dealership. They are simple, but not simplistic.