INTRODUCTION
TO SHORT-TERM
LIQUIDITY
ANALYSIS
Chapter 8
CHAPTER 8 OBJECTIVES
Define liquidity and explain its role in
financial statement analysis.
 Relate financing and investing decisions
to the elements of the balance sheet.
 Distinguish between short-term and
long-term financing and investing
activities.

CHAPTER 8 OBJECTIVES
(CONT.)
Identify, calculate and interpret liquidity
measures for working capital, current
account activity, and inventory-related
conversion cycles.
 Conduct a preliminary short-term
liquidity analysis of a company or
industry.

THE OBJECTIVE OF SHORTTERM LIQUIDITY ANALYSIS
Liquidity--an entity’s ability to pay its
obligations when they are due
 Short-term liquidity

conventional meaning of liquidity
 connotes payment of short-term
obligations with cash produced from
operations
 does not disrupt productive capacity

THE OBJECTIVE OF SHORTTERM LIQUIDITY ANALYSIS

Objective—determination of an entity’s
ability to reimburse the contributors to
the core earning processes in a timely
manner
FINANCING AND INVESTING
ACTIVITIES

Balance sheet
reports the status of financing and
investing activities at a point in time
 Financing activities (liabilities and
shareholders’ equity) provide capital for
investing activities (assets)

FINANCING AND INVESTING
ACTIVITIES (CONT.)

Primary business model (Exhibit 8-1)
Captures the essence of the initial funding
of an entity
 Company acquires funds from investors
and allocates them to productive resources

FINANCING AND INVESTING
ACTIVITIES (CONT.)

Operating business model (Exhibit 8-2)




Captures the essence of the continual funding of
an entity
Distinguishes between long and short-term
financing activities
Relates long and short-term financing activities to
long and short-term investing activities
Examines the convertibility of current assets into
cash in the near-term
TERMS AND CONCEPTS

Operating cycle (Exhibit 8-3)
Length of time required to convert a
current asset into cash
 Measures inventory transfer into
receivables and ultimately cash for
manufacturers and merchants

TERMS AND CONCEPTS
(CONT.)

Operating cycle
Measures length of time a service entity
needs to collect on services rendered
(absence of inventory)
 Conversion time is usually less than one
year (this text makes this assumption)

TERMS AND CONCEPTS
(CONT.)

Current accounts
Current assets—cash or resources that will
be converted into cash (or consumed in
the case of prepaid expenses) within one
year
 Current liabilities—obligations paid in cash
or otherwise satisfied within one year

TERMS AND CONCEPTS
(CONT.)

Working capital
Initial measure of short-term liquidity
 Computation: current assets – current
liabilities

LIQUIDITY MEASURES
(CONT.)

Current (working capital) ratio
Computation: average current assets /
average current liabilities
 General interpretation—large ratio indicates
sufficient liquidity; small ratio could mean
liquidity problems

LIQUIDITY MEASURES
(CONT.)

Factors affecting current ratio
Industry in which the firm operates
 Ability to sell inventory and collect
receivables
 Timing of cash collections and payments

LIQUIDITY MEASURES
(CONT.)

Quick ratio
Computation: (average current assets less
inventory and prepaid expenses) / average
current liabilities
 General interpretation—conservative
measure of short-term liquidity
 Drawback—unrealistic assessment of the
value of inventory

LIQUIDITY MEASURES
(CONT.)

Activity measures



Activity (turnover) ratio—quantifies the number of
times a liquid account turns over in the ordinary
course of business
Number of days in a current account—measures
the length of time needed to sell, collect, or pay
for a current account
Complementary measures: activity measures and
number of days both report an aspect of a current
account’s liquidity
LIQUIDITY MEASURES
(CONT.)
Inventory activity measures
 Inventory turnover—number of times
inventory is sold during a reporting period




Computation: cost of goods sold / average
inventory
General interpretation—the greater the turnover
the better
Number of days in inventory—length of time
needed to sell inventory


Computation: 365 days / inventory turnover
General interpretation—the lower the number of
days the better
LIQUIDITY MEASURES
(CONT.)
Accounts receivable measures
 Accounts receivable turnover—number
of times accounts receivable are
collected in a reporting period

Computation: revenues / average accounts
receivable
 General interpretation—the greater the
turnover the better

LIQUIDITY MEASURES
(CONT.)

Number of days in accounts receivable
inventory—length of time needed to
collect accounts receivable
Computation: 365 days / accounts
receivable turnover
 General interpretation—the lower the
number of days the better

LIQUIDITY MEASURES
(CONT.)

Inventory conversion cycle
Quantifies the operating cycle
 Computation: days in inventory + days in
accounts receivable
 General interpretation—the lower the
number of days in the cycle the better as
current assets are quickly converted into
cash

LIQUIDITY MEASURES
(CONT.)

Accounts payable turnover—number of times
accounts payable are paid in a reporting
period



Computation: cost of goods sold / average
accounts payable
General interpretation—the lower turnover the
better
Number of days in accounts payable—length
of time needed to pay vendors


Computation: 365 days / accounts payable
turnover
General interpretation—the greater the number of
LIQUIDITY MEASURES
(CONT.)

Net cash conversion cycle
Quantifies the financing period of current
accounts
 Computation: days in inventory + days in
accounts receivable – days in accounts
payable
 General interpretation—the lower the
number of days in the cycle the better as
less capital is invested in working capital

eSTUFF’S SHORT-TERM
LIQUIDITY RATIOS
Liquidity Ratios
Working capital
Working capital ratio
Quick ratio
Inventory turnover
Days in inventory
Accounts receivable turnover
Days in accounts receivable
$
2003
2002
2001
481 $ 442 $ 257
4.45
5.42
2.80
2.21
2.74
1.17
2.64
2.77
2.93
138.02 131.99 124.43
7.82
7.87
9.23
46.67
46.36
39.54
eSTUFF’S SHORT-TERM
LIQUIDITY RATIOS (CONT.)
Liquidity Ratios
Inventory conversion cycle
Accounts payable turnover
Days in accounts payable
Net cash conversion cycle
2003
184.69
8.42
43.34
141.34
2002 2001
178.35 163.97
11.06 6.29
33.00 58.07
145.35 105.91
LIQUIDITY ANALYSIS OF THE
PC INDUSTRY

Working capital analysis
Working capital accounts dominate the
industry’s balance sheets (Exhibit 8-5)
 Current ratios decreased over the period
examined (Exhibit 8-6)

LIQUIDITY ANALYSIS OF THE
PC INDUSTRY (CONT.)

Activity and cycle analysis
Increases in inventory turnover (decreases
in days needed to sell inventory) was the
primary reason for the decline in the
current ratios (Exhibits 8-7 and 8-8)
 Inventory conversion and net cash
conversions cycles decreased over time
Exhibits 8-12 and 8-13)

Days in Inventory
Exhibit 8-7
Days in Inventory for the PC Industry
1994-1998
80
70
60
50
40
30
20
10
0
1994
1995
1996
1997
Apple Computer, Inc.
Compaq Computer Corp.
Dell Computer Corp.
Gateway 2000 Inc.
1998
Inventory Conversion Cycle (days)
Exhibit 8-12
Inventory Conversion Cycles for the PC Industry
1994-1998
140
120
100
80
60
40
20
0
1994
1995
1996
1997
1998
Apple Computer, Inc.
Compaq Computer Corp.
Dell Computer Corp.
Gateway 2000 Inc.
Net Cash Conversion Cycle (days)
Exhibit 8-13
Net Cash Conversion Cycles for the PC Industry
1994-1998
120
100
80
60
40
20
0
-20
1994
1995
1996
1997
1998
Apple Computer, Inc.
Compaq Computer Corp.
Dell Computer Corp.
Gateway 2000 Inc.
75 100 125 150
50
25
0
Conversion Cycles (Days)
Exhibit 8-14
Conversion Cycles for Apple Computer
1994-1998
1994
1995
Apple's Inventory Conversion Cycle
1996
1997
1998
Apple's Net Cash Conversion Cycle
LIQUIDITY ANALYSIS OF THE
PC INDUSTRY (CONT.)

Overall assessment
Data suggest that all firms were able to
meet their maturing obligations
 Dell and Gateway were in more favorable
liquidity position than Apple and Compaq,
according to the evidence
