Study: Liquidity Ratios: Current Ratio
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Slides 1-2 (0m:28s)
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Welcome to Introduction to Accounting Preparing for a User's Perspective
Liquidity Ratios: Current Ratio
In a prior topic, you learned that classified balance sheets classify assets and liabilities based on their liquidity, with the most liquid assets and the most pressing liabilities placed at the top of their respective account type. Users' use classified and comparative balance sheets to compute important liquidity and solvency ratios:
Slides 3-4 (0m:36s)
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The liquidity ratios to be discussed in this topic are listed below:
1) Current Ratio
Links to an external site. Current assets / Current liabilities
2) Quick Ratio
Links to an external site. (Current assets - inventories) / Current liabilities
3) Working Capital
Links to an external site. Current assets - Current liabilities
4) Cash Conversion Cycle
Links to an external site. (days of inventory outstanding + days sales outstanding - days payable outstanding)
Liquidity Links to an external site. ratios focus on assessing the company's ability to pay off its current liabilities as they come due within the next year.
The solvency ratios to be discussed in the next topic are listed below:
1) Debt-Equity Ratio Total liabilities / Total equity
2) Debt-Assets Ratio Total liabilities / Total assets
Solvency ratios focus on assessing the company's ability to pay off all their current and non-current liabilities as they come due.
Slide 5 (0m:22s)
Links to an external site.When companies are unable to make timely payments, they tend to be poor credit risks as well as poor investments. In fact, many companies have gone out of business not because they had a bad idea but because they ran out of cash. In other words, their cash inflows did not properly match their cash outflows. Such companies were illiquid and/or were insolvent.
Slides 6-7 (1m:21s)
Links to an external site.Liquidity Ratios: Current ratio
The current ratio is a type of liquidity ratio. It helps indicate whether a company's current assets are sufficiently large to pay off its current liabilities when they come due. The current ratio is computed as:
Let's use the following comparative, classified balance for Liquid Accounting Company (LAC) below to compute its current ratio and see what it reveals.
LAC's current ratio as of December 31, 20X1 of 2.13 is computed as follows: Total Current Assets $49,000 / Total Current Liabilities $23,000 = 2.13.
Its 20X2 ratio is 2.82 computed as follows: Total Current Assets $48,000 / Total Current Liabilities $17,000 = 2.82.
LAC's current ratio of 2.82 indicates that it has $2.82 of current assets to pay off every $1 of current liabilities coming due within the next year whereas in the prior year it had only $2.13 of current assets for every $1 of current liability. Because LAC's current ratio has increased it now appears to be more liquid.
Slide 8 (0m:34s)
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The following two tricks may help you remember how to compute and interpret the current ratio:
1) Coverage. The current ratio indicates how a company's current assets "cover" its current liabilities, that is why current assets are placed on the top of current liabilities (i.e. current assets/current liabilities) in the ratio so that they can "cover" them.
2) Current. Both the numerator (current assets) and the denominator (current liabilities) start with the word "current".
Hopefully these these two little tricks will help you remember how to calculate and interpret the current ratio.
Slides 9-10 (m:49s)
Links to an external site.Liquidity Ratios: What does the current ratio tell us and what does it not tell us?
Some analysts interpret current ratios of 2 or above as indicating that a company is reasonably "liquid" and interpret current ratios of less than 1 as indicating that the company is illiquid. However, be careful, because even if a company's current ratio is greater than 2, the company may still not be very liquid as the following discussion will illustrate.
The math in the current ratio assumes that current assets will be converted into cash and current liabilities will be paid with cash evenly over the whole year. The problem is that a company's cash collections and cash payments will not always be evenly distributed throughout a year thus creating cash flow timing differences that can create unforeseen cash flow difficulties.
Slide 11 (1m:04s)
Links to an external site.In the real world, it is possible that even though a company's current ratio is greater than 2, indicating that it is probably "liquid", its current liabilities could actually come due faster than it is able to convert its current assets into cash to pay them. For example, let's assume we have no cash inflows in January, but we have to pay our $23,000 of current liabilities in January resulting in a cash outflow. We had cash of $8 to start the month with but then we had a cash outflow of $23,000 with no inflows. This would put us in a cash deficiency position. Let's assume that in February we didn't collect anything more, and didn't have to pay any more, we're still in that deficiency position. March is the same, but then finally in April we collect the $41,000 of our accounts receivable and inventory. That finally puts us into the positive cash position that our current ratio indicated would happen. The problem was that the outflows were much earlier than the inflows creating a cash deficiency position for three months.
Slide 12 (0m:51s)
Links to an external site.One of a Chief Financial Officer's (CFO's) responsibilities is to recognize future cash flow deficiencies and put plans in place to avoid them. Here are just some of the many steps that LAC's CFO could have taken to avoid the noted cash deficiency:
a) open a bank line of credit to provide at least $15,000 in short-term financing
b) sell some of LAC's long-term assets for cash (especially if they are not being used to generate income)
c) renegotiate payment terms with its suppliers to allow later payments even if he has to pay a small late payment penalty
d) provide customers a 2% discount if they pay their bills within 10 days (2/10 net 30)
e) obtain a cash infusion from LAC's owners in exchange for additional equity
Good CFOs must be able to predict their company's future cash flow difficulties and put effective plans in place to avoid them.
Slide 13 (0m:54s)
Links to an external site.On the other hand, a company's cash flows can sometimes result in temporary cash flow surpluses. For example, let's assume that in January the company is able to collect in cash all of its inventory and receivables thus bringing in $41,000 of cash and let's assume that they don't pay their accounts payable until much later. This would result in a cash surplus for a cash ending balance of $49,000. In February, no inflows and no outflows. We stay with a cash balance of $49,000 with the same thing in March. But then finally in April, we make the $23,000 payment for accounts payable, short-term debt and wages and salaries payable, thus dropping our ending cash balance down to $26,000. This surplus period of $49,000 was not predicted by the current ratio, because it assumes that the assets are received and converted into cash evenly with the liabilities.
Slide 14 (0m:41s)
Links to an external site.In this example, the CFO should have predicted this cash flow surplus in advance and made appropriate plans on how best to use the excess cash until it is finally needed to pay off its current liabilities in April. Those plans could include:
b) investing the cash in short-term marketable securities Links to an external site.
There are many cash management options available to a CFO, but it is essential that a CFO be able to foresee cash flow deficiencies and surpluses before they happen.
Source: bizstats.com
If you want to learn how to pull up similar industry ratios on your own, please watch the following short video (1m:21s):
Obtain key financial ratios using bizstats.com website
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Please stop now and take the quiz on the current ratio. After you have completed the current ratio quiz, please move on to the next Liquidity Ratios topic covering the quick ratio, working capital and the cash conversion cycle.