I'm Larry Walther, and this is principlesofaccounting.com.
This is the final module in Chapter 4, and we'll be considering
business liquidity and further consideration of the operating cycle.
Liquidity simply refers to the ability of a firm to meet its near-term
obligations as they come due.
Obviously, a firm that has insufficient liquidity or cash or other liquid-type
assets to meet their obligations can quickly find themselves in peril.
Another definition to consider is working capital.
This is the difference between current assets and current liabilities.
In the previous module, we provided a definition of current assets and
a definition of current liabilities, and
showed how they're presented on the balance sheet.
The difference between the total current assets and
the total current liabilities is the working capital of the firm.
Now, you would hope to find a company that has positive working capital.
That is to say, that its resources that essentially are cash or will convert into
cash during the next year, or operating cycle if longer, are sufficient to satisfy
the liabilities that are due or will come due within the next year.
But that's not always the case.
Firms have alternative sources of liquidity, such as standby letters of
credits at banks, so they're able to deal with short-term liquidity crises.
Or some businesses have such a fast operating cycle that they don't need to
maintain much liquidity.
If you think about a hamburger business, for example, typically there's very little
inventory and typically there's very little in the way of account receivable.
So daily cash almost cycles right back into cash.
So the need to preserve a large cushion of working capital
may not be necessary at all, depending on the nature of the businesses.
Other businesses that leave money invested for
long periods of time in both inventory and accounts receivable
may have a greater need to be concerned about their business liquidity.
A business liquidity, while we can measure working capital,
current assets minus current liabilities, that's not always a sufficient indicator.
Because obviously, a small business would not need as much total working
capital as a large business potentially.
And so, it's difficult to make comparative assessments just in terms of the total
magnitude of the working capital.
Thus, ratio comparison comes into order.
A very popular, very common ratio, in fact, you may have already heard of this
just coincidentally if you read the business press, is the current ratio.
It's a ratio that expresses the relative amount of working capital,
that is, current assets divided by current liabilities.
Now, recognize that ratios can be manipulated.
Let's suppose a business has $10 of current assets and
$5 of current liabilities.
And suppose that 2-to-1 is viewed in their mind, or maybe in a creditor's mind,
as an inadequate current ratio.
Well, what would happen if they paid off $4 of current liabilities by using
$4 of cash?
Total current assets would drop from $10 to $6,
current liabilities would drop from $5 to $1.
And so now you would be left with a 6-to-1 ratio, $6 of current assets to $1 of
remaining current liabilities, whereas before the payoff, it was a 2-to-1 ratio.
So while they're very good indicators, they're not perfect indicators, and
they certainly are subject to manipulation in the short run.
Let's also consider another potential deficiency of the current ratio.
The company might have a large amount of money invested in inventory that's
slow-moving and not easily converted to cash.
If you calculate or compare current assets to current liabilities,
everything may appear fine.
But there still may not be enough liquidity in the form of cash and
very near, quick-type assets very near to cash, like receivables and
maybe some short-term investments, to meet the obligations that are coming due.
Because the current assets are held hostage by the inventory that's
not moving.
And so, another ratio that's oftentimes calculated to try to detect this problem
is the quick ratio.
It is a much more stringent measure of liquidity.
It compares quick assets, cash, short-term investments,
accounts receivable, things that are just right on the cusp of becoming cash.
It compares those to the sum total of the current liabilities.
So I'm showing you the ratio, cash plus short-term investments plus accounts
receivable, divided by the current liabilities.
Perhaps a better indication, truly,
of the ability to meet current obligations as they're coming due.
And obviously, that liquidity measure is vital for
a particular business to track and monitor and control so that they are able
to sustain their financial health by being able to meet obligations as they come due.