The term liquidity index refers to a calculation that allows an investor-analyst to understand the ability of a company to convert accounts receivable and inventory into cash. This metric is useful when trying to determine if a company can quickly raise cash to pay its liabilities.
Liquidity Index = ((Accounts Receivable x Average Receivable Collection Period) + (Inventory x Days to Liquidate)) / (Accounts Receivable + Inventory)
Liquidity measures allow the investor-analyst to understand the company's long term viability in terms of fiscal health. This is usually assessed by examining balance sheet items such as accounts receivable, use of inventory, accounts payable, and short-term liabilities. One of the ways to understand how quickly cash can be raised using working capital (accounts receivable and inventory) is by calculating the liquidity index.
Calculating the liquidity index allows a company's finance team, or investor-analyst, to understand how fast cash can be raised by the company using its working capital (in terms of days). Specifically, how long it takes to convert both accounts receivable and inventory into cash. While the value can be tracked over time to understand gains in terms of working capital efficiency, the liquidity index is also a useful benchmark to determine relative placement versus competitors.
The CFO of Company ABC would like to better understand how efficient the company is in terms of its ability to collect accounts receivable and the amount of inventory on hand since a significant amount of cash is tied up in these two balance sheet items. She asked her analytical team to calculate Company ABC's liquidity index over the last year as well as that for its main competitor (52.1 days).
Prior work revealed Company ABC's average receivable collection period was 36.5 days. Current inventory stood at $28,578,000, while accounts receivable is $54,900,000. Inventory turnover in this same timeframe was 6.5, or 55 days. Adding 36.5 days to the inventory turnover value provides an inventory days to liquidate of 36.5 + 55, or 91.5 days.
Using this information, the team calculated Company ABC's liquidity index as:
= (($54,900,000 x 36.5 days) + ($28,578,000 x 91.5 days)) / ($54,900,000 + $28,578,000)
= (($2,003,850,000 days + $2,614,887,000 days) / $83,478,000
= $4,618,737,000 days / $83,478,000, or 55.3 days
Since the value for Company ABC (55.3 days) was higher than its competitor's (52.1 days), the CFO asked the COO to launch a continuous improvement team to evaluate both inventory levels and the company's collection practices.