 Hello, and welcome to this session in which we will discuss liquidity ratios. Liquidity ratios are a financial statement analysis tool that's going to help us learn more about the company. Specifically, it's going to help us learn about the ability of the company to pay off its short-term debt. This lecture is part three of seven. In the first lecture, we looked at what are financial statements analysis? What is financial statement analysis? What are the tools of financial statement analysis? And these are the tools of financial statement analysis. In the second recording, we looked at horizontal analysis, vertical analysis, common-size financial statement. And in this session, we start dealing with the ratios, which is the third group of the third tools in for financial statement or the third group. And under financial ratios, specifically today, we're going to be looking at liquidity ratios. Now, the best way to explain the ratios is to actually look at numbers. And what's even more important is to play with the numbers, manipulate the numbers a little bit, to see how do they affect the ratios. Because on the CPA exam, or in the real world, or on your exam in college, you're going to have to understand, you're going to be asked to be able to analyze what happened if the numerator or the denominator change, or what could affect the numerator, what could affect the denominator, which in turn, it should affect your liquidity ratios. So I'm going to jump to the Excel sheet, take a look at the financial statements, and start to crunch in those liquidity ratios. Specifically, we're going to be dealing with this balance sheet that we did the horizontal vertical analysis for. And we have current assets here, all the current assets, all the current liabilities as well. So if you don't have it, just copy down the numbers for current assets, total current assets, total current liabilities, take a picture of it. But if you are a subscriber to my website, you can access this Excel sheet. So I'm going to go to the liquidity ratio sheet here. I'm going to start to crunch the numbers starting with current ratio. So current ratio is one of the most common ratio. And that's the first ratio you'd usually learn about in any financial statement analysis lessons. First, for every ratio, you have to understand how it's computed. Current ratio is computed by taking current assets divided by current liabilities. Now, the next thing you want to know is what are current assets, because oftentimes, students, they don't understand what's included in current assets. And usually what's included in current assets are cash, short term marketable securities, account receivable, inventory, supplies and prepaid. Those are usually the current assets. And you have to know what's included in current liabilities, accounts payable, accounts payable is one of the biggest ones, short term debt, short term debt, un-earned revenues, accrued liabilities, payroll, taxes payable, short term liabilities basically. And what you are doing is you're taking current assets and dividing it by current liabilities. To understand ratios initially, use simple numbers. So if I have two, four assets, I have or $20 of assets and $10 of liabilities, I will have a current ratio of two. What does that mean? It means it's specifically two to one. What does two to one means? It means for every dollar in current liabilities, I have $2 in current assets. Notice, I have $20 in current liabilities, $10 in current assets, $10 in current liabilities. Now, whether I have $200,000 divided by $100,000, it's going to be the same. Or if I have $200,000,000 divided by $100,000,000, it is the same. The beauty about ratio, it factors the size out. Now you could compare two companies with different sizes once you look at their current ratio. Now specifically, for our company, the one that we are dealing with, we have these numbers are being fed from the balance sheet. So 876, 875 is the current assets from year one. And what's happening is it's feeding into those numbers. So you understand where these numbers are coming from. For X1, the current ratio is 1.04. For X2, the current ratio is 0.97. Now, we need to understand now what is the meaning of this? So what is the meaning of a ratio of 1.04 versus 9.7? Is this good? Not good? Should it be higher, lower, so on and so forth? For one thing, you cannot look at one number, like 1.04, and make a judgment. You always have to compare this, put this number into perspective. If we look, if we're looking at X1 versus X2, we see in X2, current ratio deteriorated. That's all we can say. We cannot say whether this ratio is good or not good. Maybe that's the normal ratio for the industry. Maybe 0.97 is the normal ratio. So we are still in good shape. Maybe it's not. Maybe the normal ratio for this industry, the guidelines should be 1.05. So the point is you cannot make a judgment unless you have additional information. But we can learn a little bit more about current ratio by looking at it from a creditor's perspective versus an owner's perspective. The creditor, the person that lend you money, the bank, let's assume the bank, the bank wants you to have a high current ratio. Why? Because all what the bank is concerned is about durability to be paid. And durability to be paid is measured through this current ratio. The higher this current ratio, the more cushioned, the more current assets you have. Now I'll tell you some stories from the real world. I still remember, we used to have a client that he had a funeral home in Scranton, Pennsylvania. And he had, I always talk about this when I discuss current portion of long-term debt. He had, I remember, 16 different loans. And he would finance those loans constantly, like I mean constantly every three months. He would keep rolling those loans into new loans. And as a result, every time you have a long-term debt, you have to break it down into a current debt, short-term debt, and long-term debt. And if you don't know this, well, you want to make sure you understand that long-term debt is composed. So every long-term debt has a short portion and long-term portion. And always what he always complains, that we had too much in the current debt, in the short-term debt. And he would make us redo the loans again and again and again. And the reason why, because he had so many loans from the bank, and the bank had certain conditions on him, basically your current ratio has to be two and above. So that's why he was always worried that if his ratio falls below two, the bank can increase his interest rate or can call the loan, ask him to pay back the money. So the point I'm trying to make is this. Each company is unique, each industry is unique. But let me show you what's going to happen if we go back to this example that I showed you about this funeral service guy. And if I take out, let's assume, if I take out some of his long-term debt, notice let's assume this is the individual, this is his non-current debt, long-term debt. Let's assume I move $40,000. I'm going to remove $40,000. So I'm going to remove $40,000 from long-term debt, negative $40,000. So I'm going to remove $40,000 and add in it to short-term debt. And I'm going to add it here. And I'm going to add it here, say this portion, this $40,000 should be current debt. Let's see what happened to the ratio. The ratio went down to exactly one. It was 1.04. By removing $40,000, I made the ratio one. The point is it's very important to understand how do you classify? I'm going to redo this. How do you classify? How do you classify certain items on the balance sheet? Because notice, if I put, if I remove bond spayable, which is long-term debt, put it into note spayable short-term, it's going to affect the ratio. Now I put it back to the original. Now the ratio back is 1.04. So the creditor wants this ratio to be as high as possible. The owners or the investors on the other side, if this ratio is too high, they might have a concern. Why? It means you have a lot of inventory, right? You might have a lot of receivable, or you may not be utilizing the assets. You might have a lot of cash on hand. Cash doesn't give you a good return. Therefore, if you have a ratio of 3.0, what does that mean? It means you have a lot of current assets relative to your current liabilities. Why do you have too much cash on hand? Do something with it. Deploy it, buy property, plant and equipment, expand the company. So the point is, it depends on who's looking at these ratios and making those evaluation. But the point is, generally speaking, the higher, the better. But there's no magic number for any industry or for any company. For example, companies like Walmart, if you look at companies like Walmart, their current ratio is one or even less than one. You might be thinking, this is really bad because, you know, if you look at any textbook, they will say the current ratio should be two. Well, Walmart does not care. Why? Because Walmart can impose, can force their suppliers to give them 120 days to pay. Okay. So what happened? Walmart can buy on account and tell their suppliers, I'm going to pay you on 120 days. Therefore, the liability will sit in the denominator for 120 days versus when they sell to customers, they collect earlier. So there's an imbalance and the imbalance is not unhealthy. It's very good. But if you look at the ratio alone, you would think Walmart is in trouble because the ratio is one or even less than one. Again, it does not mean anything. In every ratio, as I always mentioned, you have to interpret it into assert into, put it into perspective. Okay. Too high is not good. And also too low is not good. So this is the first of one, two, three other ratios that we're going to be discussing. Before we move any further, I would like to remind you whether you are an accounting student or a CPA candidate to take a look at my website, farhatlectures.com. My motto is saving CPA exam candidate and accounting students one at a time. My resources can help you do better, understand the material, thus doing better on your CPA exam and in your accounting education. I don't replace your CPA review course. I'm a useful addition to your CPA review course. Your risk is one month of subscription. Give it a try. If not, you can't cancel. This is a list of all my accounting courses, intermediate, advanced, governmental, tax, you name it, I have it. It includes lectures, multiple choice exercises. Also, my CPA supplemental material are aligned with your Becker, Roger, Wiley and Gleam. It means they are structured the same way. So it's very easy to go back and forth between my material and your CPA review course. I also give you access to all previously AI CPA questions, 1500 questions, in addition to thousands of practice questions with detailed solution. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation, like this recording, share it with other connect with me on Instagram, Facebook, Twitter and Reddit. The second ratio we're going to be looking at is the quick ratio. Think of the quick ratio as the close relative to the current ratio. For one thing is the denominator is the same. So the denominator in both ratios is current libraries. But what happened in the numerator, we're only going to be using cash and cash equivalent, short term marketable securities and net receivables. Net receivables means just a count receivable net of the allowance. And hopefully, you know what net receivable is. What are those assets? Those assets are considered quick asset. Quick asset is because they can be easily and quickly converted into cash. So what is the current ratio trying to measure the current ratio trying to measure how fast, how bad, if something happened, and you only have cash, short term marketable securities and receivable, can you cover your current libraries, specifically the biggest number we are removing from the numerator is inventory. And for many companies, inventory could be an important asset. So let's assume your inventory becomes obsolete or you cannot sell it, you know, hit economic slowdown. Can you sell your marketable securities? Can you collect your receivable in whatever cash you have? Can you use those to pay off your liabilities? Again, the best way is to use simple numbers. Let's assume you have $10 in quick ratios, $10 in current liabilities, it means one. One means for every dollar in current liabilities, you have $1 a quick ratio. That's pretty good if you do have one to one. But it may not be the same. It might be less than one. For the purpose of our company, notice we have 588,000 and 840,000 in current liabilities. So for 20x1, it's 0.7. Always the quick ratio will be lower than the current ratio. Always. And so always is too extreme. I don't like to use the word always. But simply put, if you only have current assets of cash and cash equivalent, short-term marketable securities and receivable, they will be the same. But the quick ratio can never be less than the current ratio. Why? Because for the quick assets, you are removing from the numerator, you are removing numbers, you are not adding numbers, you are removing. Therefore, when you remove numbers from the numerator, it's going to lower your answer. That's why it's going to be lower than the current ratio. Again, in 20x2, it deteriorated, went to 0.6. Now on the CPA exam, they might ask you what happened if you pay off your liabilities? Well, you have to. The best way to do it is something like this. Let's assume you would say I have 100 in current assets, 50 in current liabilities. So my ratio now is 2. And they tell you, let's assume you paid $5 in current and in accounts payable. If you pay $5, what you do, you would say, okay, my current assets now are 95, my current liabilities are 55, and what you do and you will do a quick computation. So use simple numbers, 95 divided by 45, and your ratio will be 2.11. So your ratio will improve. So always use numbers. Don't try to memorize the concept and try to apply simple numbers to see what will happen to your ratios if something changes. So the quick ratio is basically trying to measure your short-term ability to pay your debt under extreme circumstances. Once again, if you have access to this Excel sheet, you can change some numbers here to find out what happened to your ratios here. And again, this is important if you are performing in audit because the ratio should stay stable from year to year because this is what analytical procedures is all about. Inletical procedure basically state in the absence of any special circumstances, your ratio should be around 1, your current ratio should be around 1 based on historical data. If your ratio goes down a lot or if it goes up a lot, it's a red flag. It may be a mistake, maybe the company made a mistake and counted something that's a current asset that should not be or is not counting certain current liabilities. In the absence of that, they should stay stable and that relationship is important. So this is the quick ratio. The third and the fourth ratios are basically related and those are the best two ratios to measure your liquidity. What is liquidity? Can you pay off your current debt, your short-term debt? The cash ratio is basically taken only your cash and marketable securities. So notice what we're doing. As we're moving from one to two to three, we are removing stuff from this. When we move to the quick ratio, we remove the prepaid, inventory, we remove supplies. When we're moving from the quick ratio to the cash ratio, we're also removing, now we are removing the account receivable. So all what's left is cash and marketable securities. Again, cash and marketable securities, it's going to be lower. Why is it going to be lower? Because we are removing figures from the numerator. Now what happened if you cannot collect your receivable? It means your clients, your customers are not credit worthy. And even if they are credit worthy, you gave them a certain amount of time and now you have to wait until they pay and no one is willing to buy your receivable. What happened under those circumstances? Well, for every dollar in current liabilities, you only have 14 cent to cover. But notice what happened in X2, it improved. It means in X2, you had more marketable securities and more cash relative to other current assets. And if you watch the prior recording, this is what we notice in year two, you had more cash and cash equivalent in year two. So notice it's a little bit unusual that in year two, I'm sorry, in year two, your cash ratio is higher than your year one, although for the prior ratios, quick ratio and current ratio for the other ratios, the year two was always worse than year one. So that's the cash ratio. But really, the best ratio to measure your cash ability to pay off your debt is something called current cash to debt ratio. And this is taken net cash provided by the operating activities. And this is, we're looking at the cash flow statement. And we're looking at specifically operating activities. How much cash are you bringing from operating the business and dividing this by your average liabilities? Here, the reason why we use average liabilities is because cash provided by operating activities is for the whole period, for the whole period. Therefore, you cannot use ending liabilities like we used up in the prior three ratios, because in the prior three ratios, the numerator was a balance sheet account. Here, the numerator net cash provided by operating activities is a cash flow number, and it covers a period of time, not a point in time, a whole period. Therefore, you'll divide it by the average liability. Again, the higher this number, now you want this figure to be as high as possible. So let's assume you have a current liabilities of 840. You want the numerator to be as high as possible. Now if you have exactly 840, it means you are bringing $1 from operating the business, from operating the business and that $1, for every $1 in liabilities, you are bringing $1 by operating the business and making a profit in cash to cover that liability. It is possible, but not likely. So basically, if you have 300,000, let's assume 300,000 divided by 840,840,000, how much would that be? And that will be 35 pennies. It means from your operation, from basically from your profit, from your cash profit specifically, from operating the business, you are bringing 35 pennies that could cover, that could cover 35 pennies that could cover 35% of every dollar in liabilities, which is 35 cent for every dollar. Again, the higher this number, the better off you are. And for this number, there is no limit, the higher the better, because it means you are bringing a lot of cash by operating the business. Now how would you understand this concept? How would you improve your understanding of it? That's fine. Now, we went over this. The best way to do it is to work MCQs, multiple choice questions, and you can do so at my website, farhatlectures.com. Again, I am not going to ask you to not to use your CPA review course. On the contrary, you need your CPA review course. You need your accounting course. What I offer you on farhat lectures are additional resources that's going to help you understand the material and do better. In the next session, we look at activity ratios.