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.