Welcome to finance and Excel video number 16.
Hey, if you want to download this workbook or the PDF,
click on the link directly below the video
and you can download the workbook and PDF for chapter 3.
And we've got to talk about liquidity ratios.
Liquidity, what's liquidity?
How quickly something can be converted to cash.
Can they cover their short term bills?
We talked about working capital.
Working capital is current assets
minus current liabilities.
But here's a ratio.
We talked about it a little bit in the last video,
but more in the context of learning ratios.
Here we want to talk about liquidity ratios,
in particular, the current asset, commonly used
in debt contracts, where you see the current asset
has to be a certain amount or perhaps they
have to pay some of their debt early.
CA, current assets divided by current liabilities--
for every $1 of current liability,
how many dollars of current assets
are there for us to potentially use that to pay?
Now above-- when we do this division-- above one
is generally good.
If it was 10 divided by 10, it's 1,
which means we have 10 current assets for every 10
current liabilities.
If it's 20 divided by 10, that's 2.
That means you have more current assets.
So that's pretty good.
Below 1 is generally not good.
Now it depends, as always.
If it's a small business, maybe they need more.
If it's a large business or the business has lots of access
to borrowing funds, then maybe below 1 is OK.
Now notice it says big corps, it's OK.
In the financial crisis--
let's see-- Bear Stearns at the height of it had 1 divided--
well, I don't know what it was.
But their debt, they had 40 times as much debt as equity.
So I don't know what their current ratio was.
But it was well below 1.
So sometimes, in that case, it turned out to be not good.
But sometimes businesses can get away with it.
Usually common sense, above 1 is good.
There's a bunch of interpretations
of current asset.
And we'll do a bunch of examples.
But here are some notes if you want to look through them.
They have little scribbles about what happens if certain things,
like if you incur long term debt or if you pay off short term
creditors.
We're actually going to look at these examples in Excel
so you can read that if you want later.
So current ratio-- what about the quick ratio or asset test?
Same thing except for we subtract out inventory.
Why would we subtract out inventory.
Well, this takes a little while to sell
or maybe it may be hard to sell or it's obsolete.
So people take it out.
And this is more immediate measure
of short term liquidity.
Still, another ratio, the cash ratio--
we just take cash divided by current liability--
so that means, if you had to pay it all off now,
could you do it?
Now let's go over to Excel and look at an example.
Here's our Whole Foods Market example 2005 and '06 data.
Let's go ahead and calculate first for 2005
our current ratio.
Equals, this is 2005--
so we got our cash, accounts receivable inventory, other,
and then there's the total.
So that divided by our current liabilities right there.
So 1.6, we have $1.6 in current assets
for every current liability.
So that's looking pretty good.
Now let's do for the next year.
Here's our total current assets divided
by our total current liabilities.
So it went down a bit.
Maybe they're selling inventory more.
Maybe they used up some of their cash.
As we saw from the balance sheet,
they actually bought a bunch of assets.
So that makes sense that it went down.
Now let's take out the inventory.
Now it equals-- and we're going to open parenthesis
because we need to do subtraction
before we do division.
So I'm going to say, total current assets.
This is for--
I'm actually supposed to be doing 2006 here.
So I'm going to go [SOUND] that minus the inventory--
a lot of inventory for Whole Foods--
divided by total current liabilities, right there.
That was 2006.
Now let's do 2005.
I kind of did that in reverse.
We take our total current assets minus our inventory
and divide by total current liabilities.
So again, that makes sense too.
It went down, if they're using cash to buy assets.
It makes sense that it went down.
Now let's do the cash rate ratio.
Here's all of our cash for 2005.
We'll divide it by our total current liabilities.
Now if we had to pay everything off right now,
we have 82.5 cents in cash for every $1 of liability.
That's not so bad.
And then here for 2006, what happened?
I bet you it went down.
Let's see.
So cash is right there divided by total current liabilities.
Well, so it went down a lot.
So cash went down a lot in relation
to our current liabilities.
Those are liquidity, how bankers are going to look--
if Whole Foods can pay interest, suppliers
are going to look, can they pay their bills, et cetera.
Now let's go talk about what accountants and
what the people inside the firm can do
to one measure, current ratio.
Since this is in a lot of contracts,
people know how to do a lot of things,
or tricks right before the balance sheet
is prepared to maybe make their current ratio look better.
Now I'm going to click on the sheet Current Ratio.
And you can use this sheet to go ahead and try
these calculations for yourself.
I'm just going to go through the end result.
Now we want to look at a bunch of situations.
We want to say, what happens to current ratio
when we purchase inventory.
Of course, the answer is, it depends.
And then we'll look at three depends.
I will say what happens when a supplier is paid,
when short term bank loans are paid,
and a bunch of other examples.
And again, this is what can--
in general, this is what happens to the ratio when you do this.
So if you're a manager and it's important to have
a certain current ratio, then you
need to be aware of what these actions do to our ratio.
What if we purchase inventory?
Well, of course, it will not change if you pay cash.
And the reason why is current assets--
if you pay $1 cash, it's going to go right back
into inventory, $1.
They're both current assets.
So nothing's going to change.
We add some inventory.
We decrease some cash.
We go from a ratio of 2 to 2.
Now if you pay on credit, there's two possibilities.
If your current ratio is greater than one,
it's going to go down.
Let's see how.
We start at four.
Current assets, we bought inventory.
So it goes up by 1.
So we end up with 5.
Current liabilities, AP goes up by 1.
So it's 3.
And 5 divided by 3 is 1.67, which means it'll go down.
But notice we started above 1.
If your current ratio is below 1--
so right now you have 0.8333 of current assets for every $1
of current liability.
So it's less than 1.
Now look what happens.
We start at 5, let's say.
Current assets, we add inventory once we get 6.
Current liabilities, we're at six.
We add 1 to that.
We get 7.
Well, 5 divided by 6 is 0.83.
6 divided by 7 is 0.85.
It goes up.
Next example-- oh, suppliers paid.
Well, we're going to pay some cash.
So current assets are going to go down
and current liability is going to go down.
So we're paying a supplier.
Not a long term debt-- we'll talk about that one later.
Well, again, it depends.
It depends on if current ratio is greater than 1.
So greater than 1--
we have a current ratio of 2.
So we start at current assets of 1.
Cash goes down by 1, we get 3.
Current liabilities are 2.
We pay off $1 of that.
We go down to 3.
So what's 3 divided by 1?
It's 3.
So it went up.
So yeah, that's what happens.
Now the opposite happens if we start at our current ratio
below 1.
So we start at 5, cash goes down by 1.
We get 4.
Current liability is 6.
We paid it off.
So it was down to 5.
4 divided by 5 is 0.8.
So it actually will go down.
So that's what a supplier is paid.
Now short term bank loan--
well, if it's short term, then it's
classified as current liability.
And simply what's going to happen
is your cash goes down by $1.
If you pay off, you start at 4, you go to 3.
Current liability, it can be a loan.
It goes down.
So we end up with 1.
So it goes from 2 to 3.
Ah, but the same thing just as a moment ago.
If we're starting off less than 1, we had 5.
We paid off a $1 of cash, went down to 4.
We had 6 current liabilities, which included that loan.
It went down by 1.
We go to 0.8.
Now long term debt.
I'm going to scroll down here--
long term debt paid early.
Now it's important that it's paid early
because any long term debt is on the balance sheet.
But if any of it is due within the next year,
it gets moved to current liabilities.
So it's only when you pay something early.
Here's what happens.
Cash will go down by $1.
So we start at 4.
We go to 3.
So we pay off--
but why is the cash going down?
Oh, because we paid off some debt.
But look at this.
The current liability stays the same.
That didn't change.
It was the long term debt.
So we go from 4 to 3.
2 to 2, no change.
We get a ratio of 1.5.
So that the current ratio will go down
when you pay off long term debt early.
Now what about if AR is paid?
Well, it's kind of a wash, right?
Because current assets, we have accounts receivable and cash.
So cash goes up by $1, but AR goes down.
So there's no change.
What about inventory, sold at cost?
Now usually you don't sell inventory at cost, right?
But if you do, what happens?
Well, again it's a wash.
Cash goes up by $1.
Inventory goes down.
Remember, inventory is recorded usually
at what you bought it for.
So in this case, inventory down, exactly what we paid, cash in.
So there's no change.
But if we sell inventory at a profit, well, we like that.
Look at this, cash goes up by 2.
We sold it for $2.
Inventory goes down by $1.
So we go from 4.
We actually have to add, just to show you the formula.
We take the 4--
oh yeah, we add the cash by 2, which is to 6,
subtract 1, we get 5.
Current liability is the same.
So it goes up from 2 to 2.5.
Finally, if companies are in trouble sometimes,
they're right on the cusp.
They're not supposed to have their current ratio go down,
and they're about to post their balance sheet.
Well, what do they do?
They issue long term debt to pay off short term debt.
So really what they're doing is they go out and get--
let's say they owe 10,000 in current liabilities.
They go out and take a long term loan and pay off.
So really, they're transferring long term debt or short term
debt and putting it into the long term category.
So what happens here?
Well, current assets don't change at all.
Even though the cash comes in from the loan,
immediately it goes off to pay the current liability.
So it goes from 4 to 4.
Ah, but if you pay off that CL, Current Liability--
let's say $1, it goes from 2 to 1--
it dramatically increases.
So sometimes people will do this trick right
before the balance sheet is supposed
to be created in order to raise up their current ratio.
Perhaps they were about to violate some contract
or something like that.
That's a little bit about current ratio.
In our next video, we'll come back and do turnover ratios--
a lot of really cool creative ratios
that get interesting information from financial statements.
See you next video.