American Home Mortgage Tumbles on Liquidity Issues was a major headline in the news yesterday, as the company's shares fell sharply on news that the company is having financial difficulty. So a natural question to ask is: what exactly are liquidity issues and why are they a bad thing for a business?

If you run a business, there can be times when being able to quickly come up with cash to cover your obligations is the most important thing you can do. After all, running out of money to pay essential bills and debts when they come due is something that you never, never want to have happen. Your ability to avoid this situation depends upon your business' liquidity, or rather, your business' ability to convert the assets you have into cash for the purpose of paying your liabilities when they must be paid.

But how can you determine if your business has enough liquidity to meet its needs?

That's where liquidity ratios come in! These are financial metrics that you can use to determine how much of a safety cushion your business has in covering its liabilities. These metrics include the amount of your Working Capital, your Current Ratio, your Quick, or "Acid-Test" Ratio and finally, your Operating Cash Flow Ratio.

Our tool below can take all this information and find each of these metrics for you! What's more, it also works for publicly-traded companies as well: the default values in the tool above are all taken by adding up the appropriate items from American Home Mortgage's quarterly balance sheet and quarterly cash flow statement reported on March 31, 2007:

Now, let's talk about each of these measures, focusing on their value as a snapshot of financial health:

Net Working Capital

Net Working Capital is simply the difference between the value of your current assets and your current liabilities. A positive value here means that your business will have little trouble in paying back your creditors in the short term. A negative value, on the other hand, may be a red flag:

If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis.

Current, or Working Capital, Ratio

The Current Ratio, or Working Capital Ratio is the proportion of your business' current assets to its current liabilities. Here, a larger value is better, and values over 100% are very good as they indicate that the business has more than enough in assets to fully cover all its near-term liabilities.

A current ratio that comes in under 100% in the tool above indicates some trouble. From Investopedia:

A ratio under 1 suggests that the company would be unable to pay off its obligations if they came due at that point. While this shows the company is not in good financial health, it does not necessarily mean that it will go bankrupt - as there are many ways to access financing - but it is definitely not a good sign.

Quick, or Acid-Test, Ratio

The Quick Ratio, also called the Acid-Test Ratio is similar to, but represents a more conservative measure of financial health than the Current Ratio, as it does not consider the value of a company's inventory among its current assets. Removing the value of inventory from the total value of a company's current assets makes sense in that it can be difficult to convert inventory into cash on short notice.

Aa company with a Quick Ratio less than 100% for our tool should be considered to not be in good financial health, but has all the same options that a company with a Current Ratio less than 100% does. Investopedia notes some characteristics of companies with low Acid Test Ratios:

... if the acid-test ratio is much lower than the working capital ratio [Current Ratio], it means current assets are highly dependent on inventory. Retail stores are examples of this type of business.

Operating Cash Flow Ratio

The Operating Cash Flow Ratio is the proportion between the cash flow you receive from operating your business to your current liabilities and is perhaps the single best indicator of its long-term liquidity, or better, its ability to pay bills (liabilities) over time with the cash generated from operating the business.

A value less that 100% in the tool above indicates that the company's cash flow is not sufficient to solely meet its debt obligations. That means that funding must be obtained from elsewhere if the business is to survive.

American Home Mortgage

Using the default data, we can see that American Home Mortgage (AHM) was already in a world of hurt back on March 31, 2007. What's changed since then is that the company's financial situation has become more dire, which is reflected in the company's stock price as the market has become more aware of its increasing poor liquidity situation, particularly beginning in mid-June 2007:

As a business or stock owner, you never, never want to see something like this happen, as it indicates that bankruptcy is becoming a more and more likely outcome. Where AHM is concerned, we suspect we'll know our answer soon enough....

Previously on Political Calculations

• Predicting Bankruptcy - Our tool that can help determine whether a publicly-traded company may be undergoing the kind of financial distress that leads to bankruptcy.
  
• A Top Ten Countdown - What are the top ten reasons why businesses fail? We apply the list to a pre-bankruptcy Air America Radio network.
  
• Turnaround and Crisis Management - What do you need to do if your business is going under? We start you down the road you need to be on!
  
• The Future of Air America - We introduced the business strategy matrix as a tool for analyzing the options available to then-failing Air America Radio.

Labels: business, tool

- posted by Ironman at 9:24 AM | Permalink | Home |