 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 shorter 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 four 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 did how do they affect the ratios because on the CPA exam or in the real world or on the on your exam in college you're going to be asked you're going to have to understand you're going to be asked to be able to analyze what happened if what happened if the numerator or the denominator changed or what could affect the numerator what could affect the denominator which in which in 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 that copy down the numbers for current assets total current assets total current liabilities take a picture of it but if you can 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 again in 20x2 before we proceed any further I have a public announcement about my company farhatlectures.com Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses my CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles my accounting courses are aligned with your accounting courses broken down by chapter and topics my resources consist of lectures multiple choice questions true false questions as well as exercises go ahead start your free trial today so current ratio is one of the most common ratio and that's the first ratio you 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 in what's included in current liabilities accounts payable it accounts payable is one of the biggest one short-term debt short-term debt and 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 the ratios initially use simple numbers so if i have two four assets i have or twenty dollars of assets and ten dollar of liabilities i will have a current ratio of two what does that mean it means it's it's specifically two to one what does two to one means it means for every dollar in current liabilities i have two dollars in current assets notice i have two twenty in current liabilities ten dollars and twenty in current assets ten dollar in current liabilities now whether i have two hundred thousand divided by one hundred thousand it's going to be the same or if i have two hundred million divided by one hundred million it is the same the beauty about ratio it factors the size out it 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 are being fed from the balance sheet so eight seventy six eight seventy five is the current assets from year one and what's happening is it's feeding into those numbers so you understand what where these numbers are coming from for x one the current ratio is one point oh four for x two the current ratio is point nine seven now we need to understand now what are the what is the meaning of this so what is the meaning of a ratio of one point oh four versus nine point seven is this good not good should it be higher lower so on and so forth for one thing you cannot you cannot look at one number like one point oh four and make a judgment you always have to compare this put this number into perspective if we look if we're looking at x one versus x two we see in x two current ratio deteriorated that's all we can say we cannot say whether this ratio is good or no good maybe that's the normal ratio for the industry maybe a point nine seven is the normal ratio so we are still in good shape maybe it's not maybe the the normal ratio for this industry the guidelines should be one point oh five 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 a 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 cushion 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 was he had a funeral home in scranton pennsylvania and he had i always talk about this when i discuss a long 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 will 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 current debt you know 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 in long-term portion and always what 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 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 since i moved let's assume i move 40 000 i'm gonna remove 40 000 so i'm gonna remove 40 000 from long-term debt negative 40 000 so i'm gonna remove 40 000 and add in it to short-term debt and i'm gonna add it here and i'm gonna 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 gonna redo this how do you classify how do you classify certain certain items on the balance sheet because notice if i put if i remove bond spayable which is long-term debt put it into notes payable short notes payable short term it's going to affect the ratio not 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 in 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 their suppliers to give them 120 days to pay okay so what happened walmart came by on account and tell them tell their suppliers i'm gonna pay you in 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 mention you have to interpret it into assert into 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 the second ratio we're going to be looking at is the quick ratio think of the quick ratio is the close relative to the current ratio for one thing is the denominator is the same so the denominator in both ratios is current liabilities 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 liabilities 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 had 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 ten dollars in quick ratios ten dollars in current liabilities it means one one means for every dollar in current liabilities you have one dollar a quick ratio that's pretty good if you do have one to one but it may not be the same it might it might be less than one for the purpose of our company notice we have five hundred eighty eight thousand and eight hundred and forty thousand in current liabilities so for twenty x one it's point seven always the quick ratio will be lower than the current ratio it deteriorated went to point six 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 one hundred and current assets fifty in current liabilities so my ratio now is two and they tell you let's assume you paid five dollars in current in in accounts payable if you pay five dollars what you do you'd 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 okay and again this is important if you are doing if you are if you are performing an audit because the ratio should stay stable from year to year because this is what analytical procedures is all about analytical procedure basically state in the absence of any special circumstances your ratio should be around one your current ratio should be around one 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 it should not be or is not counting certain current liabilities in the absence of that they should stay stable and that relationship is important okay so this is the quick ratio the third and the fourth ratio 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 when we move to when we move to the quick ratio we remove the prepaid we remove inventory we remove supplies when we move from 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 well if we again cash and marketable securities it's going to be lower why is it going to be lower because we are removing from the numerator 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 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 in x2 you're it improved 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 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 in year i'm sorry in year two your cash ratio is higher than your year one although in the prior years for the prior ratios quick ratio and current ratio for the other ratios the year two was worse was always worse than year one okay 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 this figure as to be as high as possible so let's assume you have a current liabilities of 840 you want you want the numerator to be as high as possible now if you have exactly 840 it means you are bringing one dollar from operating the business from operating the business and that one dollar you know for every one dollar in liabilities you are bringing one dollar by operating the business and making a profit in cash to cover that liability that's that's you know it could it is possible but not likely so basically if you have you know 300 000 okay 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 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 you know that could cover 35 pennies that could cover 35 percent 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