6. liqudity ratio analysis

Copyright © 2010 Pearson Education, Inc. Publishing as Prentice HallCopyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall 6-6-11
Objectives of AnalysisObjectives of Analysis
Objectives will vary depending on theObjectives will vary depending on the
• perspective of theperspective of the financial
statement user
• specific questions that are
addressed by the analysis
The identity of the user helps defineThe identity of the user helps define
what information is needed.what information is needed.

CreditorsCreditors
A creditor is ultimately concerned withA creditor is ultimately concerned with
the ability of an existing orthe ability of an existing or
prospective borrower to make interestprospective borrower to make interest
and principal payments on borrowedand principal payments on borrowed
funds.funds.

InvestorsInvestors
An investor attempts to arrive at anAn investor attempts to arrive at an
estimation of a company’s futureestimation of a company’s future
earnings stream in order to attach aearnings stream in order to attach a
value to the securities beingvalue to the securities being
considered for purchase orconsidered for purchase or
liquidation.liquidation.

InvestorsInvestors
• What is the company’s performanceWhat is the company’s performance
record?record?
• What are the future expectations?What are the future expectations?
• How much risk is inherent in the existingHow much risk is inherent in the existing
capital structure?capital structure?
• What are expected returns?What are expected returns?
• What is firm’s competitive position?What is firm’s competitive position?
The investment analyst poses questions
such as:

ManagementManagement
• How well has the firm performed and why?How well has the firm performed and why?
• What operating areas have contributed toWhat operating areas have contributed to
success and which have not?success and which have not?
• What are strengths and weaknesses of theWhat are strengths and weaknesses of the
company’s financial position?company’s financial position?
• What changes should be implemented toWhat changes should be implemented to
improve future performance?improve future performance?
Looks to financial statement data to
determine

Sources of InformationSources of Information
The analyst will want to consider the
following resources:
• Proxy statement
• Auditor’s report
• Management discussion and analysis
• Supplementary schedules
• From 10-K and From 10-Q
• Other Sources

Tools and TechniquesTools and Techniques
• Common-size financial statementsCommon-size financial statements
• Key financial ratiosKey financial ratios
• Trend analysisTrend analysis
• Structural analysisStructural analysis
• Industry comparisonsIndustry comparisons
• Common sense and judgmentCommon sense and judgment

Key Financial RatiosKey Financial Ratios
Liquidity RatiosLiquidity Ratios
Liquidity ratios measure a firm’s ability toLiquidity ratios measure a firm’s ability to
meet cash needs as they arise. Liquiditymeet cash needs as they arise. Liquidity
ratios includeratios include
• current ratiocurrent ratio
• quick or acid-test ratioquick or acid-test ratio
• cash flow liquidity ratiocash flow liquidity ratio
• average collection periodaverage collection period
• days inventory helddays inventory held
• days payable outstandingdays payable outstanding

Short-Term SolvencyShort-Term Solvency
Measures the ability of a firm to meetMeasures the ability of a firm to meet
debt requirements as they come duedebt requirements as they come due
Current RatioCurrent Ratio
Current assetsCurrent assets
Current liabilitiesCurrent liabilities

Measures ability to meet short-term cashMeasures ability to meet short-term cash
needs more rigorously by eliminatingneeds more rigorously by eliminating
inventoryinventory
Quick or Acid-Test Ratio
Cash equivalents + MarketableCash equivalents + Marketable
securities + Net receivablessecurities + Net receivables

For example, the company may have pledged itsFor example, the company may have pledged its
receivables and its inventory, or the analystreceivables and its inventory, or the analyst
suspects severe liquidity problems with inventorysuspects severe liquidity problems with inventory
and receivables. The best indicator of theand receivables. The best indicator of the
company’s short-run liquidity may be the cashcompany’s short-run liquidity may be the cash
ratio.ratio.
Cash Ratio
Cash equivalents + Marketable securitiesCash equivalents + Marketable securities

Helps gauge liquidity of accountsHelps gauge liquidity of accounts
receivable (ability to collect cash fromreceivable (ability to collect cash from
customers) and may help providecustomers) and may help provide
information about a company’s creditinformation about a company’s credit
policiespolicies
Average Collection Period
Net accounts receivableNet accounts receivable
Average daily salesAverage daily sales

Days’ Sales in Receivables (DSO)Days’ Sales in Receivables (DSO)
• The days’ sales in receivables indicates theThe days’ sales in receivables indicates the
length of time that the receivables have beenlength of time that the receivables have been
outstanding at the end of the year.outstanding at the end of the year.
The indication can be misleading if sales areThe indication can be misleading if sales are
seasonal and/or the company uses a naturalseasonal and/or the company uses a natural
business year.business year.

Measures the efficiency of the firm inMeasures the efficiency of the firm in
managing its inventorymanaging its inventory
Days Inventory Held
InventoryInventory
Average daily cost of salesAverage daily cost of sales

Offers insight into a firm’s pattern ofOffers insight into a firm’s pattern of
payments to supplierspayments to suppliers
Days Payable Outstanding
Accounts payableAccounts payable
Average daily cost of salesAverage daily cost of sales

Cash Conversion Cycle orCash Conversion Cycle or
Net Trade CycleNet Trade Cycle
• buying or manufacturing inventory,buying or manufacturing inventory,
with some purchases on creditwith some purchases on credit
• selling inventory, with some sales onselling inventory, with some sales on
credit and creation of accountscredit and creation of accounts
receivablereceivable
• collecting the cashcollecting the cash
The normal cycle of a firm that consistsThe normal cycle of a firm that consists
ofof

Helps the analyst understand why cashHelps the analyst understand why cash
flow generation has improved orflow generation has improved or
deteriorated by analyzing key balancedeteriorated by analyzing key balance
sheet accounts that affect cash flow fromsheet accounts that affect cash flow from
operating activities:operating activities:
• Accounts ReceivableAccounts Receivable
• InventoryInventory
• Accounts PayableAccounts Payable

Average collection periodAverage collection period
plusplus
Days inventory heldDays inventory held
minusminus
Days payable outstandingDays payable outstanding
equalsequals
Cash conversion or net trade cycleCash conversion or net trade cycle
Calculated as followsCalculated as follows

Days’ Sales in InventoryDays’ Sales in Inventory
The number of days’ sales in inventory ratio
relates the amount of the ending inventory to the
average daily cost of goods sold. All of the
inventory accounts should be included in the
computation.

Inventory TurnoverInventory Turnover
Inventory turnover indicates the liquidity of the
inventory. This computation is similar to the
accounts receivable turnover computation.

Days’ Sales in ReceivablesDays’ Sales in Receivables
• The number of days’ sales in receivablesThe number of days’ sales in receivables
relates the amount of the accountsrelates the amount of the accounts
receivable to the average daily sales onreceivable to the average daily sales on
account.account.
• Days’ Sales Receivables = Gross SaleDays’ Sales Receivables = Gross Sale
Net Sales/ 356Net Sales/ 356

Accounts ReceivableAccounts Receivable
TurnoverTurnover
• Another computation, accounts receivable turnover,Another computation, accounts receivable turnover,
indicates the liquidity of the receivables. Computeindicates the liquidity of the receivables. Compute
the accounts receivable turnover measured inthe accounts receivable turnover measured in
times per year as follows:times per year as follows:
Accounts Receivable Turnover =Accounts Receivable Turnover =
Net SalesNet Sales
• Average gross ReceivablesAverage gross Receivables

Operating CycleOperating Cycle
• The operating cycle represents the period ofThe operating cycle represents the period of
time that elapses between the acquisition oftime that elapses between the acquisition of
goods and the final cash realization resultinggoods and the final cash realization resulting
from sales and subsequent collections.from sales and subsequent collections.
Operating Cycle = Accounts ReceivableOperating Cycle = Accounts Receivable
Turnover in Days + Inventory Turnover inTurnover in Days + Inventory Turnover in
DaysDays

WORKING CAPITALWORKING CAPITAL
The working capital of a business is an indication of theThe working capital of a business is an indication of the
short-run solvency of the business. Computeshort-run solvency of the business. Compute
working capital as follows:working capital as follows:
Working Capital= Current Assets - Current LiabilitiesWorking Capital= Current Assets - Current Liabilities

SALES TO WORKING CAPITALSALES TO WORKING CAPITAL
(WORKING CAPITAL TURNOVER)(WORKING CAPITAL TURNOVER)
• Relating sales to working capital gives anRelating sales to working capital gives an
indication of the turnover in working capital perindication of the turnover in working capital per
year. The analyst needs to compare this ratio withyear. The analyst needs to compare this ratio with
the past, with competitors, and with industrythe past, with competitors, and with industry
averages in order to form an opinion as to theaverages in order to form an opinion as to the
adequacy of the working capital turnover.adequacy of the working capital turnover.
SalesSales
• Sales to Working Capital =Sales to Working Capital =
• Average Working CapitalAverage Working Capital

Operating Cash Flow to Current Maturities ofOperating Cash Flow to Current Maturities of
Long-Term Debt and Current Notes PayableLong-Term Debt and Current Notes Payable

Account receivableAccount receivable

INVENTORYINVENTORY

CURRENT RATIOSCURRENT RATIOS

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