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Method incorporating time complements static measures such as the more common current ratio.
A good assessment of a company's liquidity is important because a decline in liquidity leads to a greater risk of bankruptcy. FASB describes liquidity as reflecting "an asset's or liability's nearness to cash" (Statement of Financial Accounting Concepts No. 5, Recognition and Measurement in Financial Statements of Business Enterprises). Creditors often incorporate into loan covenants minimum measures of liquidity that borrowers must maintain. Investors and analysts are interested in a company's ability to generate cash and to have enough cash available to meet everyday demands, and vendors are interested in whether a com- pany will regularly have cash available to pay for purchased goods. Liquidity is also important to external auditors for responsibilities such as assessing issues of going concern.
Given the growing emphasis on risk assess- ment within companies, public accounting practitioners performing such engagements, as well as internal auditors, could also ben- efit from reliable measures of liquidity in helping management to better understand vulnerabilities.
In assessing company liquidity, the most commonly used measure is the current ratio and its variations, such as the quick/acid- test ratio. These measures, however, fail to incorporate a measure of "nearness" to cash described by FASB beyond the fact that "current" generally indicates that the assets will be converted to cash or consumed dur- ing the normal operating cycle of the busi- ness, and the liabilities will be liquidated using current assets, or by the creation of other current liabilities. Nevertheless, in ac- counting and auditing textbooks, the cur- rent and quick ratios continue to be the focus of liquidity analysis.
Noticeably absent from almost all ac- counting and auditing textbooks is an ap- proach to liquidity analysis that incorporates the element of time-the cash conversion cycle (CCC), which was introduced in 1980 by Verlyn Richards and Eugene Laughlin in their article "A Cash Conversion Cycle Approach to Liquidity Analysis," Financial Management, Vol. 9, No.l (Spring 1980). Consideration of the CCC along with the traditional measures of liquidity will lead to a more thorough analysis of a compa- ny's liquidity position.
This article describes the CCC approach and demonstrates how static measures of liquidity can be misleading if used ex- clusively, while the...