Description: The liquidity index measures the number of days it would take to convert accounts receivable and inventory into cash. This is useful for determining a company’s ability to generate sufficient cash to meet upcoming liabilities.
Formula: Multiply the accounts receivable balance by the average number of days required to liquidate it (see the “Average Receivable Collection Period” calculation). Then multiply the inventory balance by the average number of days required to liquidate it (which includes both the number of days to sell the inventory and the number of days to collect the resulting accounts receivable). Then add these two items together and divide them by the sum of all accounts receivable and inventory. If the accounts receivable or inventory balances tend to fluctuate significantly, an average figure can be used for both. The formula is as follows:
(Accounts Receivable x Days to Liquidate) + (Inventory x Days to Liquidate)
Accounts Receivable + Inventory
Cautions: The chief difficulty with the liquidity index is that it is based on average collection periods, and so does not yield a great deal of precision in regard to the exact amount of cash that will be available on a certain day. For example, if a company tends to collection the bulk of its cash on a specific date (perhaps from a single large customer), real cash flows will be largely based on the arrival of that single payment, despite the average cash flow figure revealed by the liquidity index.