Liquidity of Short-term Assets; Related Debt-Paying Ability
It is very important for companies to look at ratios as it is an assessment of their performance
compared to their competitors and to their past performances.
The comparison must also be done against other companies in the same industry as other
industries would not give an appropriate evaluation. Evaluating amongst themselves will give a
preview on where they stand in the market.
The results attained must show an upward trend as it indicates improving patterns of the
company’s performance. At the same time, it also helps the company to be favorable for most
stakeholders as the results depicts that the company will be rewarding to invest in. Stakeholders
who are interested can be shareholders, creditors etc. These stakeholders can perform a financial
ratio analysis with the provided financial statements of the company, which includes the Balance
sheet and Income Statement.
To perform a ratio analysis, the elements of the Income Statement and Balance Sheet must be
observed as each component’s relationship can be understood. For example, the relationship
between Current Assets and Current Liabilities. Also, the ratios must be at a certain level as they
can’t be too high.
A good ratio isn’t determined by how high it can be but how it is maintained at a certain level. For
example, an ideal current ratio is 2:1, and if it exceeds that, it will show that the company is
overcapitalizing on their current assets. It presents that the company has not been managing their
current assets efficiently. Companies can understand their ratios well if they compare it against
the industry average ratio or if it is logical. If their current assets are worth 5 million and their
current liabilities are worth 1 million, then it is illogical to have 5 million current assets to cover
their current liabilities. Moreover, they can compare it with how they have performed in the
previous years by juxtaposing them with their old ratios and recent ratios.
We have different kinds of ratios:
1. Liquidity ratios
2. Solvency ratios
3. Profitability ratios
4. Asset turnover
And with these ratios we can perform an investor analysis. This type of analysis allows investors
to decided whether to buy more shares, sell shares, join the company or leave it.
The ratios also helps for people who are unfamiliar with financial statements to understand the
situation of the company through financial ratio analysis.
Liquidity ratios
There are 3 ratios that are very important and clearly talks about liquidity.
The assets has a complicated side amongst the current sides.
Liquidity is the highest form of cash
And there are three categories of cash:
1. Cash
2. Realized in cash (we have to receive them)
3. - Restricted cash (must be carefully used by the company as they have plans to use this
portion of cash. The purpose could be a formation of the business, product launch,
construction or R&D)
4. - Unrestricted cash (can be used by the company in any way they want)
5. Conserving the use of cash
Main element of asset is:
Current Assets
Cash or equivalent of cash.
Equivalent of cash: cash in bank, cash in current account, cheques, certificates of deposit
Certificate of Deposit (CD) - (savings account with a fixed amount that will be kept for 6-12
months)
In a bank, there is a fixed deposit account, savings account. In a savings account, a fixed amount
can be kept up to one year and the bank will allow you to keep it with a small amount of interest.
The bank will give the person a certificate as proof that there is an amount that is fixed and can’t
be withdrawn within one year. It is a current asset as it is one year, if the company withdraws it
before the due date, the money can’t be attained but still have access to the account. And if they
don’t break it, they can withdraw with the interest.
Accounts Receivables (Net of Receivables)
Gross Receivables - Allowances for doubtful debts = Net Receivables
Inventory
Marketable securities
Prepaid Expenses
Current Liabilities
Accounts payable
Expenses Payables
Bank Overdraft (overdrawing your bank account and its given for a period of 6-12 months)
We must first have our working capital, and this amount shows how much can be spent on the
company’s day-to-day operations.
WC = Current Assets - Current Liabilities
The result of this must be positive. It shows that the company has enough current assets than
current liabilities to meet the requirements of running the day-to-day operations of the company.
There are instances where current liabilities exceeds current assets but this negative value must
not last for more than 2 years. If it has been going long period, this means that the company does
not have sufficient funds to run the company. Hence, it must be a positive value.
Current Ratio: Current Assets/Current Liabilities
Or Working Capital: CA/CL
It shows a ratio of the working capital.
It measures the company’s liquidity and its ability to meet its payments obligations.
The value must be positive and the most preferred is 2:1. It shows that 2 current assets are
covering 1 liability. In some cases, the company may end up with 3:1 as there are some who
attempt to avoid a dangerous situation where they may reach solvency. Hence, they keep 1 more
asset to cover their current liabilities. Or 2.5:1
From 2:1-3:1 is the most preferable ratio as anything beyond or less that is unacceptable. The
company must not block up too much money in their current assets, which can be indicated if the
ratio is greater than 1, as the company will be unable to use their money in purchasing certain
fixed assets or for other purposes that can help with the company’s efficiency.
Some people may also say is 1.5:1. This case, the company is able to have available money to
invest in certain assets that can contribute to their profitability. They must not block up their
money as they have other assets that they can use.
Anything below or above this range (1.5-3) will put the company in overcapitalization or undercapitalisation.
Quick Ratio = Current Assets - Inventory/Current liabilities
It is also called Acid-test ratio.
If the company is put into acid, how fast can it recover?
Shows how fast they can recover or convert their assets into cash.
It includes the quickest current assets in proportion to current liabilities.
The base will always be current assets/current liabilities. To make the ratio quicker, we must take
out the asset “inventory”, as this asset is the slowest to be converted into cash. It takes almost
6-12 months to be converted. Inventories can also be obsolete or it can be delayed, many issues
are involved.
It gives a real ratio of the company.
Some companies also do not have inventory as they are non-manufacturing. A company that
takes a long time for its inventory to be converted into cash can depict a poor current ratio.
Hence, this ratio only includes:
1. Cash
2. Marketable securities
3. Prepaid Expenses
4. Accounts Receivables
The preferable ratio: 1.5:1, and 2:1 or 2.5:1 is not needed as more cash will be added if
inventory is included. However, 2:1 doesn’t show a bad representation of the company.
Anything above 1 is favorable but below that is unfavorable, it means that they don’t have
enough current assets to support their current liabilities.
Cash ratio
The most liquid form of cash.
Cash ratio = Cash + Marketable Securities/Current Liabilities
We are including the most liquid assets and compare it against current liabilities.
We include marketable securities because they are also in the form in cash. If they were to be
converted right now, cash will be received instantly as compared to other assets.
This is done when a company has too much cash or they want to compare cash with their current
liabilities.
The preferred ratio is above 1. Anything that is below 1 is not preferable. They don’t have to have
2 as this means that all their money is in cash against current liabilities.
this ratio is helpful when the company is very risky as the measurement of cash for current
liabilities is important to know in those situations.
We can use this know how much cash we have against current liabilities of the company.
Sales to working capital ratio
Sales to working capital ratio = sales/average working capital
We take average working capital because we are making a historical analysis of the working
capital. It will include the previous working capital.
Low ratio means there’s low sales and its not profitable. the ratio must be from 1.5 to 2 and if its
too high, the company is undercapitalized. More money is in fixed assets and less is in current
assets. There is too much money in net profit and there isn’t enough in retained earnings. If the
ratio is low, the company isn’t performing well enough to generate high sales.
Sales adds to working capital.
Asset Turnover is a separate principle in some countries.
Ratios measures how fast the company can turnover or how assets can be turned into
cash.
Asset Turnover ratios include:
a. Inventory Turnover ratio
b. Accounts Receivable turnover
c. Operating Cycle
d. Asset turnover
2 main turnover aspects of a company is:
1. Inventory - eventually the asset will turn into cash
2. Accounts Receivable - cash must be received at a later date if goods or services were sold
on credit.
A) Inventory Turnover
It measures how fast or how many times a company has sold and replaced their inventory in a
year. It can be calculated in days or per year.
Inventory includes:
1. Raw Materials
2. Work in Process
3. Finished Goods
It takes a longer time, like for 3-6 months, for manufacturing companies to convert their inventory
into finished goods as they are leveled in 3 stages. They have to convert them from raw materials
into finished goods, then sell it and receive the bill to replace their inventory with new ones. In
contrast, a service or retailer company will take a shorter time as they already have finished goods
on hand. They also have to make sure that they have to sell their inventory quickly. Their inventory
may be close to its expiry date, or new items are close to arrival and all old items must be
removed. This is why many stores hold clearance sales.
It can be calculated on days or per year.
Inventory turnover in days = average inventory/(cost of goods sold)/365
We divide cogs by 365 because we are attempting to get it by the number of days.
Inventory turnover per year = 365/Inventory turnover in days
Just inventory turnover = cost of goods sold/average inventory
Why average inventory?
There are three forms of valuing inventory.
1. LIFO - Whatever is purchased or entered in inventory recently will be sold first
2. FIFO - (most common one) The first portions that has entered in inventory will be sold first.
3. AVCO - Average cost or medium range of the two inventories in the business.
Whatever method is used to value inventory, there will always be an understatement or
overstatement of income statement and balance sheet.
LIFO: As we are selling inventory that has been recently entered, the prices can be different from
the other units of inventory.
Bought 20 units for 5 dhs
Next batch of 20 units was bought for 3 dhs.
Last batch of 20 units was bought for 6 dhs.
The batch differences is different. Hence, any method of inventory valuation will result to either
overstatement or understatement of income statement.
The ending inventory in the balance sheet and the cost of goods sold in the income statement will
be different amongst the 3 types of inventory valuation. As a result, the methods may either lower
or increase profit. To avoid this, we must take the average of the inventory.
Add the beginning and ending inventory and divide them by 2 to get the average. Make these two
extremes into a midrange so the difference won’t be reflected as much.
Accounts Receivable Turnover
This measures the duration of how fast or how long it will take for a company’s customer’s to pay
them in cash. The customers may not have cash at the moment so they bought the company’s
goods or services on credit. The company must get the cash as a result.
Measures how fast can the company convert its bills into cash on sales. It is not a good sign if it
takes a long duration as they need cash to meet other obligations they can pay from the cash to
be collected from customers.
The company must make sure that the turnover is low. Especially if its a retailer, it is expected to
have a low turnover. however, it is also expected that manufacturing companies will take a longer
period before cash is realized from their accounts receivables as it takes a long time to produce
the product, sell it and earn its profits with cash.
The more the company waits, the longer it’ll take for them to receive their cash.
The retail will expect the customer to pay for the purchase immediately.
Accounts Receivable turnover = Net sales/average gross receivables
We use net sales as it excludes sales discounts. And we divided them with average gross
receivables. We will not deduct our allowances of doubtful accounts as we expect to come back.
We will expect whatever has been billed to our customer. If the allowances is under control, we
will consider average gross receivables.
If its in days we will flip them:
Average receivable turnover in days: average gross receivables/(net sales)/365
The earlier the days, the better. If the days are longer than it was last year, then the company is
performing poorly in receiving cash from their receivables.
Operating Cycle
Accounts Receivable Turnover in Days + Inventory Turnover in Days
It is important to know how efficient the company is in selling their goods to receive cash.
This operating cycle shows the duration between acquiring the goods for the first time and
the period when final cash is realized.
A company buys goods on January and they sell in march and get the cash in April. Operating
cycle.
A long operating cycle means its bad for the company. The company must keep an eye on their
operating cycle.
The cycle of purchasing the inventory and the time when cash is received from customers.
It consists of the inventory turnover in days as it shows how long it’ll take for inventory to be
converted into cash, or sold to customers. The accounts receivables then measures how long it’ll
take to receive the cash from the customers, as a result, the operating cycle is complete.
Asset Turnover
Sales/Total Assets
How efficiently
How efficiently you use your sales and assets to contribute into everything in good shape.
How fast or efficiently use the assets of the company to have a better sales and cash for the
company.
Net sales/Total assets (fixed assets + current assets + Intangible Assets)
Liquidity ratios are important for creditors to show that the company is reliable when it comes to
paying their liabilities.
The ratios can be bad in terms of the preferred range, but it doesn’t mean that the company is
performing poorly. Other ratios may be favorable and it can indicate that fixed assets are being
handled more efficiently than current assets.
Undercapitalisation = too much liquidity that fixed assets aren’t being utilized efficiently or are
insufficiently being invested in.
they have insufficient capital to perform normal business operations and to pay creditors.
Poor liquidity ratios can also mean that fixed assets are used more efficiently than current assets,,
om the condition that profitability ratios and solvency ratios are doing well. This also means that
the company is doing well