 Hello and welcome to the session in which we would look at liquidity ratios, liquidity ratios cover the short term ability of the company to pay off its debt. It includes current ratio, quick ratio and the cash ratio. Before I start I would like to remind you to connect with me on LinkedIn if you haven't done so. On my YouTube farhatlectures.com you will find additional resources to complement or supplement your accounting as well as your CPA exam. I don't replace your CPA prep course. I don't replace your Wiley, Glyme, Becker or Roger. What I do is I complement so if you add me to your CPA accounting course you can add 10 to 15 points to your CPA exam. Also you could subscribe to my YouTube where I have plenty of accounting finance, tax and audit lectures and connect with me on Instagram and Facebook. Starting with the first two current ratio and the quick ratio and you're going to notice that these three ratios current quick as well as the cash ratio we're going to see in a moment they all have the same denominator which is current liabilities. So they are all somehow showing us our ability to pay off our current liabilities. Now what are current liabilities? Current liabilities are liabilities that obligations that are due within the next 12 month or the company's operating cycle we're going to assume it's the next 12 month. So simply put we are looking at figures and signals to see if we can meet the our obligation for the next 12 month. Is this is this an issue in the real world? Of course it's a serious issue. If you cannot pay off your debt that's coming due in the next 12 month and you cannot refinance to pay off your debt you're going to be in big trouble because if you cannot operate you have to close your business. So that's why current current ratio quick ratio and the cash ratios the liquidity ratios are important in evaluating the company's health short term as well as long term prospects. Starting with the current ratio the current ratio simply put taking current assets divided by current liabilities. It measures the ability of the firm to pay its current liabilities by liquidating its current assets. What is liquidating? It means turning them then turning their current assets into cash. Now it indicates the firm's ability to avoid insolvency that's a problem in the short term. Now so on the CPA exam or on your exam you're going to be asked how for example you might be asked a simple question as compute the current ratio. Well the current ratio is current assets divided by current liabilities and to understand this just use simple numbers. For example say if I have ten dollars or ten million or ten billion of current assets and five dollars or five millions of current liabilities it doesn't matter. Ten divided by five the answer is two. The important thing is for you to understand what does the answer mean. Okay what does the answer to mean? It means for every dollar in liabilities you have two dollars in assets. Simply put if I simplify this ratio what happened if I simplify this ratio it becomes two over one. It means for every one dollar in liabilities I have two dollars in assets. Now generally speaking historically and it doesn't it's I don't think it holds true anymore. A ratio of two for current ratio is good. It is supposed to be good. Nowadays you really don't know each company is different each industry is different but you want at least to have a current ratio of one. Even less than one now it's not an issue anymore but again we don't want to you know that's beyond the scope of this lesson but each ratio is is kind of different. You have to look at the industry. You have to look at prior periods to interpret this ratio. Now the other thing that you could be asked about when it comes to current ratio is let's assume you increase your current liabilities without increasing your current assets or let's assume they will ask you let's assume you paid off two dollars of your current liabilities or three dollars or four dollars of your current liabilities. What happened to your current ratio? Let's assume you paid four dollars. Well let's assume you paid four dollars. If you paid four dollars your current assets will become six and your current liabilities if you paid four dollars becomes one. Okay so notice what happened by reducing your, by reducing your liabilities by 4, okay, the ratio becomes 6 divided by 1, which is your ratio went up. Let's assume you increase your current assets and current liabilities by 4. So it's going to be plus 4, which is going to be 14, not plus 14. So the new ratio will be 14 and denominator will be 9. So let's compute this ratio, 14 divided by 9. So notice what happened to your current ratio is 1.55, it deteriorated. So reducing your current assets and current liabilities by 4 is not the same as increasing your current assets and your current liabilities by 4. Now, don't mean on the exam or especially on the CPA exam, what you should do, you should just jot down some easy numbers and do the computation before you jump into the conclusion. So simply put, companies to improve your short term, and hopefully this makes sense, to improve your short term ability to pay off your debt, reduce, try to reduce your debt, okay. So reducing your debt and reducing your current assets by the same amount is better than increasing your current assets and increasing your current liabilities by the same amount. Always the best way to value ratio or to compare ratio to something else, to a benchmark, to a prior year to an industry. For example, here this company, their current ratio was 1.46, 1.17, 0.97. So what's happening to the current ratio for this sample company, it's deteriorating as time goes by, current ratio is going down. And look at the industry ratio, the industry ratio by 2017, it's double that of that company. I would say this company is going to be running into trouble unless they have a good explanation why their current ratio is half of the industry. Now from the current ratio, we're going to be looking at the quick ratio, very similar, except that we're going to do some changes in the numerator. What does the current assets include? So I did not mention what the current assets include. Current assets include cash, marketable securities, receivable. Also current assets include inventory, it includes prepaid, it includes supplies. Those are the other accounts and current assets. What's going to happen with the quick ratio? We are going to say, well, guess what? Your inventory became unsellable, you're prepaid, you cannot really sell them and your supplies you need to operate. So we're going to compute now the quick ratio. It's also called the asset test ratio. In the numerator, we're only going to keep cash and cash equivalent, such as marketable securities and receivable. Basically, marketable securities also include short-term investments. That's all we're going to keep in the numerator. We're going to assume the other assets, the other current assets, inventory, prepaid and supplies, they're either not converted into cash or they're not really worth anything. Now basically, the quick ratio is a better measure. Now we are becoming more stringent. Now we're assuming let's happen if our inventory is no longer saleable. What's going to happen? It's like a more stringent. It's like a stress test. It's a measure of liquidity that's harsher than the current ratio for firms assuming the inventory is not readily convertible into cash. Same concept. Now historically, a quick ratio of one is good. Historically, that's the industry standard. Always, the quick ratio is lower than the current ratio. Always. Why? Because when you compute the quick ratio, you're going to be taken away stuff from the numerator. Then your number, your answer, should go down. Let's take a look at the current ratio, 0.73, 0.58, 0.49. It's also deteriorating. Of course, it's going to deteriorate. If the current ratio is deteriorating, the quick ratio will deteriorate. And notice by 2017, the quick ratio was half of the industry. Once again, this company is facing some short-term solvency. Short-term solvency. That's what these two ratios are telling us. Now we need to know why. We need to know why. Why do they have too many liabilities in relationship to their current assets? Maybe it could be just one potential explanation is that they have really a strong hand with their suppliers. In other words, for example, for their accounts payable, for example, they have 120 days to pay. But with the receivable, they collect their money earlier, but they keep their receivable longer on the book, so it looks as if they have more payable. It could be. But we need to know why. We need to know why their current ratio and their quick ratio are deteriorating. Now, in the real world, the other thing you want to understand is this. Especially now I'm speaking from an auditor's perspective. Those ratios should not change that much from year to year. Given everything else is equal. If you're operating your business, you're going to maintain the same amount of receivable and payable over the years because if you sell more, you're going to buy more. If you sell less, you're going to buy less. So if we're talking about account receivable and accounts payable, you're going to keep the same amount of cash on hand relative to your operation. You're going to keep the same amount of supplies. You're going to have the same accrued liabilities and payrolls. So they should not change that much. That's the other thing that's unusual about this company. It's going down and it's going down substantially. Those ratios should not change unless there's a good explanation why they should change. The third ratio, which is also related to 1 and 2, is the cash ratio. This is as stringent as it gets. What does the cash ratio represent? It represents how much cash you have on hand now. It doesn't matter what's going on with the receivables and inventory. We don't care about any of those. We just want to know how much cash we have on hand, just cash and marketable securities. Marketable securities are really considered quasi-cash or cash equivalent. Same thing, you're looking at your cash divided by your current liabilities. Companies receivable are less liquid than it's holding of cash and marketable securities. So take the receivable out. Let's assume we cannot convert the receivable into cash. It is less liquid, but you could usually sell the receivable and if you're desperate, you could always sell it at a deep discount, but you could sell it. Therefore, in addition to the quick ratio, analysts also compute the cash ratio. And I believe that's the most accurate figure about your ability to pay off your current liabilities because you're going to pay your current liabilities with cash. In my opinion, the other two ratios are indicators where the company is heading, but your true ability, whether you can pay or not be able to pay, your liabilities is through your cash and marketable securities and specifically cash to be more specific. And notice here, again, it's going to be lower than current ratio, lower than the quick ratio because you are taking more from the numerator and keeping the denominator current liabilities the same. And notice by 2017, they have half the amount of the cash in relationship to the current liabilities as compared to the industry standard, which is not good. And they don't have enough cash and this is a serious problem. In the next session, we would look at market price ratios. As always, I'm going to invite you to visit my website, farhatlectures.com, especially if you are studying for your CPA exam. As I mentioned earlier, I don't replace your courses. I explained the material a little bit slower, as you can tell, little bit more in details than your CPA course. And if you're taking an accounting course, it should help you tremendously. Good luck, study hard, and most importantly, stay safe until we are done with this COVID. Good luck.