Okay, now what are some of the ratios that
we’re going to be concerned with? And there are a variety of ratios that we look at. Some
of the ratios that you’ll see. There’s the current ratio, quick ratio, inventory turnover
ratio, receivable turnover, debt to equity ratio and so on. So some of the ratios of
concern for us. Current ratio. Current ratio is current assets
over current liabilities. It tells us how solvent the company is. If you’ve got four
to one, that’s good. If you’ve got one to four, that ain’t so good. Then we’ve got what
we call the quick or the acid test ratio and that’s going to be these assets that are quickly
convertable to cash. Of your current assets, which are quickly
convertable? How about cash? How about marketable securities because a marketable security has
a market. I own 100 shares of Apple, could I sell it today? Sure. How about accounts
receivable, net AR? Well receivables, would someone buy your receivables? Could you factor,
pledge, discount receivables? Yes you could, so they have a value. Divided by current liabilities.
So what’s missing from here to here? Here, this includes inventory. With inventory, can
you quickly convert inventory? No, because you may have inventory that obsolete. You
may have inventory that’s overvalued. It’s not lower of cost or market and so on. So
therefore, that’s not part of the quick or acid test.
We have what we call accounts receivable turnover ratio. What is turnover? Whenever you see
the word turnover, take the name and turn it over. So it’s going to be something over
average AR. Hmm, okay, and now accounts receivable comes out of what? Sales but what kind of
sales? Total sales? No, because a total sale– If somebody pays you cash what’s the probability
of collecting it? 100 percent as long as it’s not counterfeit fake money. So it’s going
to be net credit sales. So credit sales over average AR, that’s going
to give you some kind of ratio, let’s say 6.0. What does 6.0 mean? It means that your
receivables turnover six times a year or every two months. That tell you valuation that maybe
your receivables are so old that they’re not going to be collectable. So if you’re going
to buy– Let’s say you want to buy my company and I go hey, I’ve got accounts receivable
of one million dollars, I’ll sell them to you for one million dollars. You’re going
to say, wait a sec, how much are they really worth? That’s where you have to go out and
you’ve got to figure out how often do they turnover.
If receivables turnover six times a year or every two months and I’ve got receivables
that are six months old, you’re going to go, dude they should have zero value. I’m not
going to pay you face value for those, they’re not worth it. That’s where you have to go
through and we learn in financial accounting about an aging of AR or basically so we’re
going through and we’re aging zero to 30 day old, we’re going to assume two percent�s
on collectable. 30 to 60 days old, five percent. 60 to 90 days old, 10 percent and so on. So
you’re aging them to see what the real value should be, that’s called average AR. So that
tells you how many times. Another one is called inventory turnover.
Again, flip it something over average inventory. How about costs of goods sold? Now what does
that tell you? That tells you that– Let’s say its 6.0 that tells you inventory turns
over six times a year or every two months. So I’m selling you my company or you�re
evaluating my balance sheet and you go, hey, inventory turns over six times a year or every
two months, if you have inventory that’s three months old, maybe it’s obsolete. Maybe we
need an inventory adjustment. Maybe my inventory is milk and its six months old, it isn�t
salable. It’s called buttermilk. So the point is, we’re going to have a lot of adjustment
inventories overstated. Again, get into the mindset. The client wants
to make themselves look bigger, better, stronger, healthy. So what do they do? Overstate assets,
overstate receivables, overstate inventory. Those receivables, they ain�t collectable.
Inventory, it ain’t salable, right? You can’t sell it. No one wants it. So those are the
purpose of ratio. Debt to equity, total liabilities divided by total stock holders� equity.
Those are just some of the different ratios. Now in your notes you’ll see that we put a
whole list of important ratios. You will see these in some of the questions. I don’t want
you to memorize them all but as you�re doing the homework, if they’re asking you about
a particular ratio, go ahead and refer back to the table, back to the chart so you can
kind of work through it and see if the numbers make sense.
You’ll see here, they’re broken up between liquidity, which measures the company’s short
term ability to pay its obligations. Activity, measures how effectively the company uses
its assets. Profitability, measures the degree of success or failure of a given company or
division for a given period of time, profitability. Coverage measures the degree of protection
for long term creditors and investors. Okay so, some of these– Okay, working capital
is what? Current assets minus current liabilities. So that is current assets minus current liabilities
and here you’ll see the purpose or use measures the company’s solvency. How solvent am I?
My current assets minus current liabilities. Current ratio, that’s this one, current assets
divided by current liabilities measures short term debt paying ability. So this is short
term because it’s current over current liabilities. Quicker acid test, cash, marketable securities,
receivables, divided by current liabilities measures immediate short term liquidity.
So notice here, this one is more accurate than this because it includes everything that’s
quickly convertible. That’s why it’s called the quick or acid test. Because it’s all your
current assets quickly convertible into cash. Current cash debt, coverage ratio, net cash
provided by operative activities over average current liabilities, measures the company’s
ability to pay off its current liabilities in a given year.