Introduction to Short-term Liquidity Analysis

8/14/2019 Introduction to Short-term Liquidity Analysis

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INTRODUCTION

TO SHORT-TERMLIQUIDITYANALYSIS

Chapter 8


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CHAPTER 8 OBJECTIVES

Define liquidity and explain its role infinancial statement analysis.

Relate financing and investing decisionsto the elements of the balance sheet.

Distinguish between short-term and

long-term financing and investingactivities.


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CHAPTER 8 OBJECTIVES(CONT.)

Identify, calculate and interpret liquiditymeasures for working capital, current

account activity, and inventory-relatedconversion cycles.

Conduct a preliminary short-term

liquidity analysis of a company orindustry.


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THE OBJECTIVE OF SHORT-TERM LIQUIDITY ANALYSIS

Liquidity--an entitys ability to pay itsobligations when they are due

Short-term liquidity

conventional meaning of liquidity

connotes payment of short-term

obligations with cash produced fromoperations

does not disrupt productive capacity


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THE OBJECTIVE OF SHORT-TERM LIQUIDITY ANALYSIS

Objectivedetermination of an entitysability to reimburse the contributors to

the core earning processes in a timelymanner


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FINANCING AND INVESTINGACTIVITIES

Balance sheet

reports the status of financing and

investing activities at a point in time Financing activities (liabilities and

shareholders equity) provide capital forinvesting activities (assets)


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FINANCING AND INVESTINGACTIVITIES (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


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FINANCING AND INVESTINGACTIVITIES (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


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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 formanufacturers and merchants


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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 oneyear (this text makes this assumption)


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Current accounts

Current assetscash or resources that will

be converted into cash (or consumed inthe case of prepaid expenses) within oneyear

Current liabilitiesobligations paid in cashor otherwise satisfied within one year


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Working capital

Initial measure of short-term liquidity

Computation: current assets currentliabilities


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LIQUIDITY MEASURES(CONT.)

Factors affecting current ratio

Industry in which the firm operates

Ability to sell inventory and collectreceivables

Timing of cash collections and payments


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Quick ratio

Computation: (average current assets less

inventory and prepaid expenses) / averagecurrent liabilities

General interpretationconservativemeasure of short-term liquidity

Drawbackunrealistic assessment of thevalue of inventory


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Activity measures

Activity (turnover) ratioquantifies the number of

times a liquid account turns over in the ordinarycourse of business

Number of days in a current accountmeasuresthe length of time needed to sell, collect, or payfor a current account

Complementary measures: activity measures andnumber of days both report an aspect of a currentaccounts liquidity


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Inventory activity measures

Inventory turnovernumber of times

inventory is sold during a reporting period Computation: cost of goods sold / average

inventory

General interpretationthe greater the turnoverthe better

Number of days in inventorylength of timeneeded to sell inventory Computation: 365 days / inventory turnover

General interpretationthe lower the number ofdays the better


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Accounts receivable measures

Accounts receivable turnovernumber

of times accounts receivable arecollected in a reporting period

Computation: revenues / average accounts

receivable General interpretationthe greater the

turnover the better


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Number of days in accounts receivableinventorylength of time needed to

collect accounts receivable Computation: 365 days / accounts

receivable turnover

General interpretationthe lower thenumber of days the better


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Inventory conversion cycle

Quantifies the operating cycle

Computation: days in inventory + days inaccounts receivable

General interpretationthe lower the

number of days in the cycle the better ascurrent assets are quickly converted intocash


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Accounts payable turnovernumber of timesaccounts payable are paid in a reportingperiod Computation: cost of goods sold / average

accounts payable

General interpretationthe lower turnover thebetter

Number of days in accounts payablelengthof time needed to pay vendors Computation: 365 days / accounts payable

turnover

General interpretationthe greater the number of


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Net cash conversion cycle Quantifies the financing period of current

accounts Computation: days in inventory + days in

accounts receivable days in accountspayable

General interpretationthe lower thenumber of days in the cycle the better asless capital is invested in working capital


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eSTUFFS SHORT-TERMLIQUIDITY RATIOS

Liquidity Ratios 2003 2002 2001

Working capital 481$ 442$ 257$

Working capital ratio 4.45 5.42 2.80Quick ratio 2.21 2.74 1.17

Inventory turnover 2.64 2.77 2.93

Days in inventory 138.02 131.99 124.43

Accounts receivable turnover 7.82 7.87 9.23

Days in accounts receivable 46.67 46.36 39.54


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eSTUFFS SHORT-TERMLIQUIDITY RATIOS (CONT.)

Liquidity Ratios 2003 2002 2001

Inventory conversion cycle 184.69 178.35 163.97

Accounts payable turnover 8.42 11.06 6.29Days in accounts payable 43.34 33.00 58.07

Net cash conversion cycle 141 34 145 35 105 91


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LIQUIDITY ANALYSIS OF THEPC INDUSTRY

Working capital analysis

Working capital accounts dominate the

industrys balance sheets (Exhibit 8-5) Current ratios decreased over the period

examined (Exhibit 8-6)


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LIQUIDITY ANALYSIS OF THEPC INDUSTRY (CONT.)

Activity and cycle analysis

Increases in inventory turnover (decreases

in days needed to sell inventory) was theprimary reason for the decline in thecurrent ratios (Exhibits 8-7 and 8-8)

Inventory conversion and net cashconversions cycles decreased over timeExhibits 8-12 and 8-13)


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Exhibit 8-7

Days in Inventory for the PC Industry

1994-1998

0

10

20

30

40

50

60

70

80

19981997199619951994

DaysinIn

ventory

Apple Computer, Inc. Compaq Computer Corp.

Dell Computer Corp. Gateway 2000 Inc.


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Exhibit 8-12

Inventory Conversion Cycles for the PC Industry

1994-1998

0

20

40

60

80

100

120

140

19981997199619951994

InventoryConversionCycle(days)




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Exhibit 8-13

Net Cash Conversion Cycles for the PC Industry

1994-1998

-20

0

20

40

60

80

100

120

19981997199619951994NetCa

sh

ConversionCycle

(days)




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0

25

50

75

100

125

150

Conv

ersionCycles

(Days)

19981997199619951994

Exhibit 8-14

Conversion Cycles for Apple Computer

1994-1998

Apple's Inventory Conversion Cycle Apple's Net Cash Conversion Cycle


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LIQUIDITY ANALYSIS OF THEPC 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

Documents

Introduction to Short-term Liquidity Analysis