How can you assess a company's liquidity using its cash flow statement?

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Liquidity is the ability of a company to meet its short-term obligations with its available cash and liquid assets. A company's cash flow statement shows how much cash it generates and uses from its operating, investing, and financing activities over a period of time. By analyzing the cash flow statement, you can assess a company's liquidity in various ways. Here are some of the most common methods.

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Hanan Hasbullah

Senior Accountant @ Coreo Real Estate | Head of Finance
Lucas L.

FP&A | Corporate Finance | FMCG | Strategic Financial Analyst | Guiding Strategic Decisions with Data-Driven Analysis

1 Cash flow from operations

Cash flow from operations (CFO) is the amount of cash that a company generates from its core business activities, such as selling goods or services, paying wages, or buying inventory. CFO reflects the quality and efficiency of a company's operations and its ability to generate cash from its revenues. A positive CFO indicates that a company can cover its operating expenses and invest in its growth. A negative CFO indicates that a company is spending more than it is earning and may face liquidity problems. To assess a company's liquidity using CFO, you can compare it to its current liabilities, which are the obligations that are due within a year. A higher ratio of CFO to current liabilities means that a company has more cash to pay off its short-term debts and avoid default.

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Lucas L.

FP&A | Corporate Finance | FMCG | Strategic Financial Analyst | Guiding Strategic Decisions with Data-Driven Analysis
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Very good point Hanan, on top of this, we can also use ratios crossing cash flow statement with balance sheet, such as the Operation Cash Flow Ratio, which is defined by the OCF / Current Liabilities. This ratio indicates the ability of a company to cover its short-term obligations through its operating cash flow. A ratio > 1 suggests that the company is generating more cash from its operation than its required to cover its short-term obligations, whilst less than 1 suggests that the company is not generating enough cash from its operations. However, excessively high ratios may indicate that the company is not efficiently utilizing its cash for other purposes, such as investments or debt reduction.

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Hanan Hasbullah

Senior Accountant @ Coreo Real Estate | Head of Finance
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OCF is the cash generated or used by a company's core operations. A positive OCF signals financial health and funds for daily expenses, debt payments, and investments. For example, if a company's OCF is $1 million, it means they generated $1 million from their day-to-day activities during a specific period. Vital for assessing a company's financial stability.

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2 Free cash flow

Free cash flow (FCF) is the amount of cash that a company has left after paying for its operating expenses and capital expenditures, such as buying or maintaining fixed assets. FCF measures a company's financial flexibility and its ability to fund its growth, pay dividends, or repay debt. A positive FCF indicates that a company can generate enough cash to meet its current and future needs. A negative FCF indicates that a company is consuming more cash than it is producing and may need to raise external financing or cut costs. To assess a company's liquidity using FCF, you can compare it to its total debt, which is the sum of its short-term and long-term borrowings. A higher ratio of FCF to total debt means that a company has more cash to reduce its debt burden and improve its creditworthiness.

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Hanan Hasbullah

Senior Accountant @ Coreo Real Estate | Head of Finance
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FCF is the amount of cash a company has left after covering its operating and capital expenditure (CapEx) costs. It's a key metric for assessing a company's ability to generate surplus cash, which can be used for debt reduction, dividends, investments, or other strategic purposes. FCF is a critical indicator of financial strength and flexibility, helping companies make informed decisions about their capital allocation.

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3 Cash conversion cycle

Cash conversion cycle (CCC) is the number of days that it takes for a company to convert its inventory into cash. CCC reflects how efficiently a company manages its working capital, which is the difference between its current assets and current liabilities. A shorter CCC means that a company can quickly turn its inventory into sales and collect cash from its customers. A longer CCC means that a company has to wait longer to receive cash and may incur higher inventory and financing costs. To assess a company's liquidity using CCC, you can compare it to its industry average or its competitors. A lower CCC than the industry average or the competitors means that a company has a competitive advantage in managing its cash flow and liquidity.

By using these methods, you can assess a company's liquidity using its cash flow statement and identify its strengths and weaknesses in generating and using cash. You can also use other indicators, such as net working capital, current ratio, or quick ratio, to complement your analysis and get a more comprehensive picture of a company's liquidity position.

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Hanan Hasbullah

Senior Accountant @ Coreo Real Estate | Head of Finance
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CCC is a financial metric that measures how long it takes for a company to convert its investments in inventory and accounts receivable into cash. A shorter CCC indicates more efficient cash management, while a longer CCC can tie up cash resources. It's a crucial metric for managing working capital and optimizing a company's cash flow.

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4 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How can you assess a company's liquidity using its cash flow statement?

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1 Cash flow from operations

2 Free cash flow

3 Cash conversion cycle

4 Here’s what else to consider

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