Liquidity — short-term survival
Chapter 1 of 12 · 4 min
Why liquidity is the most acute stability variable
10x Insight
Quick ratio (Acid Test Ratio) = (Current assets − Inventory) / Short-term liabilities.
The dividing line between liquidity and solvency
A company can be solvent (lower liabilities than assets) and still go into bankruptcy — if it cannot pay its short-term liabilities on time. This is the difference between solvency (long-term viability) and liquidity (short-term survival). Solvency is about the company's total balance sheet — are the assets greater than the liabilities? Liquidity is about the company's cash flow — can the company pay bills that fall due this month? A company with 1 billion in assets and 500 million in liabilities is solvent, but if 600 million of the liabilities fall due tomorrow and the company only has 100 million in cash — it goes bankrupt.
Liquidity is the most acute form of financial risk. AKM1 measures liquidity via the quick ratio (also called 'acid-test ratio'): (current assets − inventory) / short-term liabilities. >1,0 is considered safe; <0,5 is acute crisis.
📖 DEFINITION
Quick ratio (Acid Test Ratio) = (Current assets − Inventory) / Short-term liabilities. AKM1: p1 = <0,5 (acute), p2 = 0,5-0,8 (low), p3 = 0,8-1,2 (normal), p4 = 1,2-2,0 (good), p5 = >2,0 (very strong).
Why inventory is excluded
The quick ratio is more conservative than the 'current ratio' (current assets / short-term liabilities) because it excludes inventory. The reason: inventory is often difficult to sell quickly at full value. A retail company with 100 million in garments cannot immediately convert this to cash — they must sell at a discount (50-70% of book value). An industrial company with 200 million in semi-finished goods has it even harder — this can take months to sell. A construction company with ongoing projects has 'inventory' that may take 2-5 years to convert to cash. The quick ratio answers the question: 'if the company's revenue stopped tomorrow, could they pay short-term liabilities with cash + accounts receivable?' Receivables are included because they can normally be sold (factoring) or collected within 30-90 days.
💡 INSIGHT
Inventory is excluded from the quick ratio because it is difficult to convert quickly to cash. A retail company with a 'good' current ratio of 2,0 can have a quick ratio of 0,8 if it has a lot of inventory — bad hidden behind a good number.
The shortest time horizon in stability
AKM1 has three stability variables with different time horizons. The debt-to-equity ratio (V10) measures long-term financial structure — survival over 5-10 years. Cash flow stability (V12) measures medium-term predictability — survival over 1-3 years. Liquidity (V11) measures the shortest time horizon — survival over 30-90 days. A company with a good debt-to-equity ratio and good cash flow stability can still have an acute liquidity crisis if accounts receivable are not paid on time or if the overdraft facility is fully utilized.
Lehman Brothers 2008 is the classic example — the company was solvent on paper (assets > liabilities), but when short-term funding sources froze, they could not pay daily obligations and went under in 48 hours. Liquidity is the most 'silent' risk — it arises quickly and without warning.
⚡ KEY INSIGHTS Solvency (long-term) ≠ liquidity (short-term) — companies can be solvent but go bankrupt from lack of liquidity The quick ratio excludes inventory — it is too difficult to convert quickly to cash Liquidity has the shortest time horizon (30-90 days), debt the longest (5-10 years) Lehman 2008 was solvent but went under in 48 hours — liquidity crisis 2