Document Type

Article

Publication Date

8-1-2007

Abstract

Although most analysts apply static measures such as the current ratio or the quick ratio to assess a firm's short-term liquidity, a separate calculation of dynamic integrative measures can tell a completely different story about a firm's ability to meet its short-term obligations. One important difference between the two types of measures is that the static measures assume that a firm will be liquidated, while the integrative measures evaluate the liquidity of the firm as a going concern. Analyzing a sample of restaurant and manufacturing firms from 1994 through 2003, the static measures of liquidity imply that restaurant companies are illiquid, while manufacturing companies are liquid. However, when the same companies are evaluated under an integrative framework, restaurant firms were shown to be the more liquid ones, based on their financial and operating liquidity. Compared to restaurants, manufacturing firms exhibit a certain amount of operating illiquidity due to the length of their cash-conversion cycle (that is, the time it takes to generate revenue from the expense of adding and processing inventory). The analysis suggests that financial analysts, creditors, and managers should evaluate both dynamic liquidity measures and static measures in assessing short-term liquidity, since each measure provides different information about a company's ability to cover its obligations. Moreover, when evaluating a company's liquidity over time, one must pay careful attention to the sources of any changes in a company's liquidity position. The finding that restaurants, particularly owner-operator firms, have high operating liquidity should be an argument for favorable short-term financing terms, even though static ratios make restaurants seem like poor risks. An accurate evaluation of short-term liquidity may improve restaurants' cost of short-term financing, overall financing costs, and required returns from equity investors.

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