INSIDE INVESTOR: Avoiding the liquidity trap

Here’s another tip on measuring the health of your company.

Last week we talked about solvency. Another equally important measure is liquidity. In fact it is probably more important.

That’s because a company’s balance sheet may show that it is solvent – that it has more assets than liabilities – but the key measure of financial health is liquidity. For a company to remain trading, it has to be able to pay its debts when they are due.

How could a solvent company collapse? If it has more assets than liabilities, there shouldn’t be a problem. Right? Wrong.

It all depends on the kind of assets the company is holding. An office tower in the city may be a good asset. But it isn’t as easily converted to cash as say shares or government bonds.

If you take a look at that balance sheet again, you’ll notice that both assets and liabilities are split into two groups. At the top of the page, there will be columns detailing Current Assets and Current Liabilities.

The word Current has a specific meaning in accounting. It means “within the next 12 months”. So Current Assets are assets that can be converted into cash easily, within that one year period.  Any cash the company has is listed in this column.

Current liabilities are debts that fall due within that 12 month period.

So you can see the potential for problems. A company may have conservative debt levels overall, compared to its assets. But it may not have enough readily available cash to settle looming debts.

This doesn’t always spell disaster. Most lenders try to work around these kinds of problems because often they are short term issues that can be resolved.  It is in no-one’s interest for a company to collapse.

But it was these kinds of liquidity issues that brought companies such as Centro to their knees during the financial crisis.

From an investor’s point of view, the annual report is the first place you look when you think you want to do some research on a company in which you are planning to invest.

Remember, read what the chairman and chief executive have to say in the annual report first. Then check the auditor’s statement. And then have a look at the balance sheet and look for solvency issues and the liquidity situation.