 Hello and welcome to the session. This is Professor Farhad and this session we would look at liquidity ratio. This topic is covered in internet intermediate accounting, financial statement analysis course and on the CPA, BEC exam as well as the CMA exam. If you haven't connected with me only then please do so. YouTube is what I house all my lectures 1500 plus accounting, auditing, finance and tax lectures. If you like my lectures, please like them. It helps tremendously. Put them in playlist, share them, let the world know about them. If you're benefiting from them, it means they might benefit other people. I do also have a website on my website. In addition to my lectures, I have notes, PowerPoint slides, exercises, CPA questions, 2000 CPA questions. If you're interested, please check out my website. Liquidity ratios. Let's talk about the liquidity ratios in general. What do they measure? What are you trying to measure? Now, each ratio and we're going to go over the liquidity ratio. We're going to go through the activity ratios. We're going to go over different ratio. But the liquidity ratio of the ratio is a liquidity ratio. It's measuring your short term ability to pay off your debt. Do you have enough money? Basically, do you have enough money so we can keep on going in the short term? This is what it's covering. Can you pay your current maturities, accounts payable, short term notes, accrued liabilities, so on and so forth? Do you have enough money to keep on going? It measures the short term risk, which is important because if you cannot survive in the short term, you cannot survive in the long term, of course. To measure liquidity, we're going to be computing three different ratios, the current ratio, the asset test ratio and the current cash debt coverage ratio. And we're going to go over each one of them separately, starting with the current ratio. How do we compute the current ratio? Well, it's current assets divided by current liabilities. Basically, the current ratio measures our short term debt ability, short term debt paying ability. I wouldn't say it's very good. You're going to see the other ratios are better, but it's a starting point to measure that. So in the numerator, notice we have current assets and you have to know what current assets are. Cash, account receivable, short term investments, prepaid, supplies and others. I skipped inventory. Inventory will be there as well. It's a big one. Inventory. Now think about it. Measure short term debt paying ability. Well, if you have a prepaid, how good is that? It's not that good. What about supplies? Not that good. Also, inventory may not be very good if you cannot convert it quickly to cash. In the denominator, you have your current liabilities such as accounts payable, short term notes, salary payable, unearned revenues, all accrued liabilities, any short term liability. Now, let's look with some simple numbers to show you how you read those ratios. Let's assume they told you current assets is 100, current liabilities is 50, 100 million or 100,000 or 100,000. It doesn't matter. So the answer will be two. How do you interpret the answer to or two to one? What is two to one? It means for every $1 in liabilities, you have $2 in current assets. You have $2 in current asset, $1 in current liabilities. You can cover your current liabilities twice with your current assets. Now, on the CPA exam, they might ask you or on your exam, they might ask you what happened if we increase our liabilities and don't increase our assets. For example, there would be something like this. What happened if our current liabilities went up? What happened to the ratio? Don't memorize those scenarios. Start with something like this. If 100 is current assets, 50 current liabilities, just take out the 50 and let's assume I have 100 in current liabilities. I increase my liabilities. My answer is now one to one. What happened to my ratio? My ratio went down. So simply put, don't memorize those formulas. Just plug in some easy numbers, especially on the CPA exam. Don't memorize them. Same concept would apply. As they told you, what happened if current assets were increased without increasing current liabilities? Plug some numbers and see what would happen. Obviously, your coverage will increase. So this is what you need to do with those what-if analysis. Now, current ratio, it can be looked at from a different perspective. From a creditor's perspective, people that lend money to the company, a high current ratio, they're very comfortable with that. Why? Because it means the company, they have plenty of liquidity, which may or may not be true. They may not have, if they have a lot of inventory, inventory may not be liquid, but they prefer a high current ratio because they're interested in protection. The higher the current ratio, the higher is the protection, the higher the likelihood of them being repaid. From the owner's perspective, if you're the stockholder, well, you might look at the same current ratio as a negative sign, suggesting that the company's asset are being deployed too conservatively. Simply put, if it's too high and you are the stockholder, you might saying, why are you having too much inventory on hand or why do you have a lot of supplies or relative to current liabilities? You are not deploying your asset properly. You are being conservative. If it's too high, it means you are not really, because think about it. From a business perspective, the higher the risk, the higher is the return, but also the higher is going down too as well. So risk means the higher the return. But having too much asset tied up in current assets may not be the best thing. From an operating perspective, a high current ratio could be a sign of conservatism. Once again, you are being protected, protected of your assets. You have enough current assets to meet your current liability or the natural result of a competitive strategy that emphasize liberal credit terms and sizeable inventory. Simply put, it could be also the fact that you sell on account a lot as a result. You have a lot of account receivable, account receivable as an asset, and you have a lot of inventory. Inventory, it's going to generate more higher current assets, and maybe you're financing your inventory with long term debt. So that could be also a sign of debt. Ratios are just signals. They'll tell you something and you have to follow up. So by themselves, they don't mean anything. You just tell you something, but you have to follow up. Again, the important question is not whether a ratio is too high or too low or whatever the situation is. Does it fit the company's strategy? What does that mean? Well, maybe the company wants to have fast expansion. Well, if you're going to have fast expansion, if you want to gain market share, you're going to have to loosen your credit terms. You want to sell to more people on account. Well, if you sell to more people on account, your account receivable relative to your competitors might go up. As a result, you're going to have a high current ratio. That could be the case. That's why. Are you in a dominant position? If you're in a dominant position, you may not need that much protection. Is your industry mature? If you're industry mature, you may not need a lot of inventory. So it all depends on what industry you are in. So you have to interpret those ratios within that context. The second ratio we're going to look at is the quick or sometimes it's called quick or asset test ratio. I like to be called the quick ratio. How do you compute the quick ratio? It's taken the numerator, the quick assets. Those are the assets that can be quickly converted to cash and we're going to see what they are. Sometimes this ratio is called the stress ratio. I'll tell you why in a moment. In the denominator, it's going to be the same as the current ratio, which is current liabilities, accounts payable, salaries payable, so on and so forth. So this is the asset test ratio. So all what changed is the numerator. And what happened to the numerator? In the numerator, we only kept three assets. We kept cash. We kept cash. We kept marketable securities, which are short term investments, which are current assets and receivable net account receivable. So those are the three assets. Cash is one, marketable securities two, and account receivable is three. Those three assets are considered quick asset. Quick asset means they can be quickly converted into cash. So now what would happen is now we said let's assume our inventory becomes obsolete. We cannot use the prepaid to pay our current liabilities. We cannot use the supplies. What would happen in that situation? Well, remember, we started with 100 to 50 in the current ratio. This is the number that we started with. Now what's going to happen is the 50 is going to stay the same, but your assets might drop down to 50. Now you have 50 of quick assets, 50 of current liabilities. The answer is one. Again, back to the same question is one good. Again, you cannot answer that question. You cannot answer whether one is good or not. You have to look at different indicators. For example, what was the current ratio the same? What was the current ratio during the same period last year, during the same quarter? What's your quick ratio compared to the industry? What's your quick ratio compared to a certain competitor? What's your quick ratio based on how much you want it to be? So that's why you have to look at it, but this ratio is more stringent. It tells you what happened if you are under extreme business condition. Can you pay off your current liabilities? So it measure immediate, immediate short-term liquidity. So it's more stringent than the current ratio. And it's always going to be less than the current ratio because you're taking out numbers from the numerators. It's going to be always less than the current ratio unless you only have cash marketable securities and receivables. It will equal to the current ratio. Another ratio is the current cash debt coverage ratio. I believe that's the best one. It's taken net cash provided by operating activities, divided by the average current liabilities. Notice here we use the average. I'll explain why in a moment. And that's going to measure the company's ability to pay off its current liabilities in a given year from its operation. Here, let's take a look at the numerator first. The numerator comes from the statement of cash flow, net cash provided by operating activities. This is basically net income on a cash basis, coming from the statement of cash flow, statement of cash flow. And the ability, it's basically measuring our ability to generate cash from operation to cover our current liabilities. In my opinion, that's the best ratio. And even another good ratio is cash, simply cash, divided by current liabilities, simply cash. Okay, that's another good ratio because you're going to pay your liabilities with cash. But net cash provided by operating, it tells you the cash that you are generating this period relative to your current liabilities. That's a good one too. So either cash divided by current liabilities or net cash provided. I believe this is a better one. This tells you what's going on life. Because you could have cash. I think this one is better. This one is better than just cash. Because you could have cash from common stock, coming from common stock. You can have cash coming from long term debt. You could have cash coming from selling your property, plant and equipment. Those are not good sources of cash or not healthy sources of cash. So the best way to measure your ability, this ratio. I say this is the best ratio in my opinion. The denominator is average current liabilities, not the just current liabilities. Not just current liabilities. And maybe you're asking why? Why do we use average current liabilities and not current liabilities? Good question. The reason is this. In the numerator, you have net cash provided by operating activities. This cash provided by operating activities is being generated for a period of time. So it's generated from the beginning of the period to the end of the period. So you cannot have a number in the numerator that's only covering a period of time and divided by ending current liabilities. If you divided by only ending current liabilities, so you're taking a number that's covering a period of time and you're divided by a number, a point in time. So if the numerator is for a period of time, which is the net cash provided by operating activities. It's over a period of time, over a quarter, over a semi-annual or an annual period. Well, your numerator has also to take the full period into account. Now, we cannot keep track of our current liabilities constantly, but we can compute the average. What's the average taken the beginning plus ending divided by two? So this is why we use the average. Some final notes about ratios. Ratios help us identify the company's present strength and weaknesses. It just tells you what's going on and believe it or not, in the real world, you use ratios on a regular basis, whether you are doing an audit or you are preparing financial statements like a compilation or a review, because they tell you a lot. If there's any error, if there's any entry, that's if something does not make any sense. If somebody made a mistake, the ratios would reveal them because the ratios will be out of balance. You always have, for example, you would expect the current ratio to be 1.7. Well, it could be 1.69, it could be 1.72. But let's assume you computed the current ratio and the ratio is 1.8. Well, we have to look into it. There's something wrong because the expectation is 1.7, it's 1.8, or it go down to 1.5. It could happen, but it's going to give you a red flag. What's going on? Why? Why our ratio changed substantially? Because generally speaking, again, generally speaking, generally speaking, ratios should be stable. What does that mean? If they improve, that's better. But generally speaking, for a normal company, that's not going through fast growth or deterioration. If it's not going through those two stages, if it's a normal time, ratios should be equal. So if your account receivable goes up, your account spable should go up. Because if you are selling more, you're going to be buying more on account. So on and so forth. So keep that in mind. Keep that in mind. So that's why they give you a lot of indication. They give you a red flag. So they are basically a red flag. This is how you would look at them. Remember, one single ratio on its own is useless. You cannot look at one ratio to make any good decision. So don't even think about this. You have to look at the full picture. And to derive meaning from ratios, analysts or auditors or users, they need some standard against which to compare them. So you cannot just say, what is 1.7? Is this good? Is this bad? You don't know. I mean, you don't know. You have to put it into perspective. How do you put it into perspective? You compare it to the industry averages. If the industry average is two, then you're not as competitive. You are worse off than the industry average when it comes to current ratio. If the industry average is 1.5, then you are better off. You have more protection than the industry. Past year amount, I believe this is a good one. Comparing period to period. I used to use this comparison a lot when I would prepare reviews because oftentimes you don't have industry averages, especially if you are preparing financial statements for a small or a medium-sized company. You have to pay money to get those industry averages. Therefore, you have to compare to something that you have. You could compare to a particular competitor. Even for small and medium-sized companies, that's difficult, but for publicly traded companies, you might be able to. If you do find a competitor, you have to take into account many adjustments. It's not like you compare them. Never it's Apple to Apple. Or you have to compare it to a planned level. The company says we would like our current ratio to be 0.7, and the current ratio is 1.7, and it's 1.7. Also, what's important about the current ratio, they're used heavily in that covenant. What does it mean by that covenant? When you borrow money from the bank, they're going to look at your current ratio, asset-test ratio, and they may impose conditions on you. What are the conditions? For example, your current ratio should not fall below 1.8. That's one condition. Now, if you fall below 1.8, there are consequences. What are the consequences? They may raise your interest rate. They may want you to pay back the loan. They can put conditions on you, simply put. When you prepare financial statements, again, this is from personal experience, and there is a debt covenant. You have to be very careful on how you compute current assets and how you compute current liabilities because it does make a difference. Because if the current ratio is incorrect, it may trigger provisions in the debt covenant that's going to affect the owner's position. Anyhow, this is the current ratio. Those are the liquidity ratios. In the next session, I might look at another sets of ratios to have a full financial statement analysis. 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