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INTRODUCTION TO SHORT-TERM LIQUIDITY ANALYSIS

INTRODUCTION TO SHORT-TERM LIQUIDITY ANALYSIS. Chapter 8. CHAPTER 8 OBJECTIVES. Define liquidity and explain its role in financial statement analysis. Relate financing and investing decisions to the elements of the balance sheet.

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INTRODUCTION TO SHORT-TERM LIQUIDITY ANALYSIS

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  1. INTRODUCTION TO SHORT-TERM LIQUIDITY ANALYSIS Chapter 8

  2. CHAPTER 8 OBJECTIVES • Define liquidity and explain its role in financial statement analysis. • Relate financing and investing decisions to the elements of the balance sheet. • Distinguish between short-term and long-term financing and investing activities.

  3. CHAPTER 8 OBJECTIVES (CONT.) • Identify, calculate and interpret liquidity measures for working capital, current account activity, and inventory-related conversion cycles. • Conduct a preliminary short-term liquidity analysis of a company or industry.

  4. THE OBJECTIVE OF SHORT-TERM LIQUIDITY ANALYSIS • Liquidity--an entity’s ability to pay its obligations when they are due • Short-term liquidity • conventional meaning of liquidity • connotes payment of short-term obligations with cash produced from operations • does not disrupt productive capacity

  5. THE OBJECTIVE OF SHORT-TERM LIQUIDITY ANALYSIS • Objective—determination of an entity’s ability to reimburse the contributors to the core earning processes in a timely manner

  6. FINANCING AND INVESTING ACTIVITIES • Balance sheet • reports the status of financing and investing activities at a point in time • Financing activities (liabilities and shareholders’ equity) provide capital for investing activities (assets)

  7. FINANCING AND INVESTING ACTIVITIES (CONT.) • Primary business model (Exhibit 8-1) • Captures the essence of the initial funding of an entity • Company acquires funds from investors and allocates them to productive resources

  8. FINANCING AND INVESTING ACTIVITIES (CONT.) • Operating business model (Exhibit 8-2) • Captures the essence of the continual funding of an entity • Distinguishes between long and short-term financing activities • Relates long and short-term financing activities to long and short-term investing activities • Examines the convertibility of current assets into cash in the near-term

  9. TERMS AND CONCEPTS • Operating cycle (Exhibit 8-3) • Length of time required to convert a current asset into cash • Measures inventory transfer into receivables and ultimately cash for manufacturers and merchants

  10. TERMS AND CONCEPTS (CONT.) • Operating cycle • Measures length of time a service entity needs to collect on services rendered (absence of inventory) • Conversion time is usually less than one year (this text makes this assumption)

  11. TERMS AND CONCEPTS (CONT.) • Current accounts • Current assets—cash or resources that will be converted into cash (or consumed in the case of prepaid expenses) within one year • Current liabilities—obligations paid in cash or otherwise satisfied within one year

  12. TERMS AND CONCEPTS (CONT.) • Working capital • Initial measure of short-term liquidity • Computation: current assets – current liabilities

  13. LIQUIDITY MEASURES (CONT.) • Current (working capital) ratio • Computation: average current assets / average current liabilities • General interpretation—large ratio indicates sufficient liquidity; small ratio could mean liquidity problems

  14. LIQUIDITY MEASURES (CONT.) • Factors affecting current ratio • Industry in which the firm operates • Ability to sell inventory and collect receivables • Timing of cash collections and payments

  15. LIQUIDITY MEASURES (CONT.) • Quick ratio • Computation: (average current assets less inventory and prepaid expenses) / average current liabilities • General interpretation—conservative measure of short-term liquidity • Drawback—unrealistic assessment of the value of inventory

  16. LIQUIDITY MEASURES (CONT.) • Activity measures • Activity (turnover) ratio—quantifies the number of times a liquid account turns over in the ordinary course of business • Number of days in a current account—measures the length of time needed to sell, collect, or pay for a current account • Complementary measures: activity measures and number of days both report an aspect of a current account’s liquidity

  17. LIQUIDITY MEASURES (CONT.) • Inventory activity measures • Inventory turnover—number of times inventory is sold during a reporting period • Computation: cost of goods sold / average inventory • General interpretation—the greater the turnover the better • Number of days in inventory—length of time needed to sell inventory • Computation: 365 days / inventory turnover • General interpretation—the lower the number of days the better

  18. LIQUIDITY MEASURES (CONT.) • Accounts receivable measures • Accounts receivable turnover—number of times accounts receivable are collected in a reporting period • Computation: revenues / average accounts receivable • General interpretation—the greater the turnover the better

  19. LIQUIDITY MEASURES (CONT.) • Number of days in accounts receivable inventory—length of time needed to collect accounts receivable • Computation: 365 days / accounts receivable turnover • General interpretation—the lower the number of days the better

  20. LIQUIDITY MEASURES (CONT.) • Inventory conversion cycle • Quantifies the operating cycle • Computation: days in inventory + days in accounts receivable • General interpretation—the lower the number of days in the cycle the better as current assets are quickly converted into cash

  21. LIQUIDITY MEASURES (CONT.) • Accounts payable turnover—number of times accounts payable are paid in a reporting period • Computation: cost of goods sold / average accounts payable • General interpretation—the lower turnover the better • Number of days in accounts payable—length of time needed to pay vendors • Computation: 365 days / accounts payable turnover • General interpretation—the greater the number of days the better

  22. LIQUIDITY MEASURES (CONT.) • Net cash conversion cycle • Quantifies the financing period of current accounts • Computation: days in inventory + days in accounts receivable – days in accounts payable • General interpretation—the lower the number of days in the cycle the better as less capital is invested in working capital

  23. eSTUFF’S SHORT-TERM LIQUIDITY RATIOS

  24. eSTUFF’S SHORT-TERM LIQUIDITY RATIOS (CONT.)

  25. LIQUIDITY ANALYSIS OF THE PC INDUSTRY • Working capital analysis • Working capital accounts dominate the industry’s balance sheets (Exhibit 8-5) • Current ratios decreased over the period examined (Exhibit 8-6)

  26. LIQUIDITY ANALYSIS OF THE PC INDUSTRY (CONT.) • Activity and cycle analysis • Increases in inventory turnover (decreases in days needed to sell inventory) was the primary reason for the decline in the current ratios (Exhibits 8-7 and 8-8) • Inventory conversion and net cash conversions cycles decreased over time Exhibits 8-12 and 8-13)

  27. LIQUIDITY ANALYSIS OF THE PC INDUSTRY (CONT.) • Overall assessment • Data suggest that all firms were able to meet their maturing obligations • Dell and Gateway were in more favorable liquidity position than Apple and Compaq, according to the evidence

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