14 Homogeneous Liquidity
Lindon Robison
Learning goals. 1. Learn how to measure an investment’s liquidity. 2. Learn how to compare liquidity for a firm versus liquidity for an investment. 3. Learn how to rank investments according to their liquidity using cash flow measures.
Learning objectives. To achieve your learning goals, you should complete the following objectives:
- Learn to distinguish between two types of returns earned by an investment: time dated cash flow and capital gains (losses).
- Learn how to distinguish between a firm’s liquidity and an investment’s liquidity.
- Learn how to describe an investment’s liquidity at a point in time by using its current-to-total returns (CTR) ratio.
- Learn how to describe an investment’s liquidity over time by using its inter temporal CTR ratio.
- Learn how to connect CTR ratios to price-to-earnings (PE) ratios.
- Learn how PE ratios can be used to infer the liquidity of an investment.
- Learn how coverage (C) ratios can be used to infer the liquidity of an investment.
Introduction
An investment may earn two types of returns (losses) for investors: (1) time-dated cash flow called current returns, and (2) capital gains (losses). This chapter demonstrates that capital gains earned on an investment depend on the investment’s pattern of future cash flow.
This chapter also demonstrates that the combination of current returns versus capital gains (losses) has important liquidity implications for investors, especially when an investment is financed with debt capital. Debt-financed investments whose earnings are expected to grow over time may experience a cash shortfall called a financing gap, in which the cash returns are less than the scheduled payments of principal plus interest. This gap is most likely to occur early in the investment’s life and is exacerbated by inflation. As time passes and the cash returns grow in size, they will eventually exceed the repayment obligation, and the liquidity problem is solved.
The term liquidity is used to describe “near-cash investments” because of the similarity between liquids and liquid investments. A liquid such as water can fill the shape of its container and is easily transferred from one container to another. Similarly, liquid funds easily meet the immediate financial needs of their owners. Illiquid investments such as land and buildings, like solids, are not easily accessed to meet financial needs because their ownership and control are not easily transferred.
A firm’s liquidity reflects its capacity to generate sufficient cash to meet its financial commitments as they come due. A firm’s failure to meet its financial commitments results in bankruptcy, even though the firm might be profitable and have positive equity. Consequently, firms must account for an investment’s liquidity in addition to earning positive net present value (NPV).
There are several measures that reflect a firm’s or an investment’s liquidity. One measure used to reflect the liquidity of t