An example of a current ratio can be found in the current sections of a balance sheet shown earlier in Chapter This is only a rough approximation for several reasons. One reason is that a company can, quite legitimately, improve its current ratio. In the Nutrimin example, let us assume that the business wanted its balance sheet to reflect a higher current ratio. By totally legitimate means, the current ratio has been improved from 3 to 5.
This technique is widely used by companies who want to put their best foot forward in the balance sheet, and it always works, provided that the current ratio was greater than 1 to start with. Treasury bills maturing in three months or less. Any accounts whose collectability is in doubt must be reduced to realizable value by deducting an allowance for doubtful debts. This condition is especially likely for goods of a perishable, seasonal, high-fashion, or trendy nature, or items subject to technological obsolescence, such as computers.
Since inventory can readily lose value, it must be reported on the balance sheet at the lower of cost or market value. This means that the amount reported for inventory on the balance sheet is what it cost to acquire including freight and insurance or—if lower—the cost of replacement or the expected selling price less costs of sale. Despite these requirements designed to report inventory at a realistic amount, inventory is regarded as an asset subject to inherent liquidity risk, particularly in difficult economic times, and especially for items that are subject to obsolescence, theft, or deterioration.
For these reasons, the current ratio is often modified by excluding inventory, so that the modified ratio is current assets excluding inventory, divided by current liabilities. This modified ratio is known as the quick ratio or the acid test ratio. This indicates that Nutrimin has a barely adequate quick ratio, with no margin of safety at all. It is a red flag, or warning signal. The current ratio and the quick ratio deal with all or most of the current assets and current liabilities. There are also short-term liquidity ratios that focus more narrowly on individual components of current assets and current liabilities.
Turnover is a key factor in liquidity. Faster turnover allows a company to do more business without increasing assets.
Increased turnover means that less cash is tied up in assets, and that improves liquidity. By the same token, slower turnover of liabilities conserves cash and thereby increases liquidity. Or, more simply, achieving better turnover of working capital can significantly improve liquidity. Therefore, turnover ratios provide valuable information. The working capital turnover ratios are described next.
The day turnover period is found by dividing a year, days, by the accounts receivable turnover ratio of 4, to get the average of 91 days. This is how long on average it takes to collect accounts receivable. That is fine if our credit terms call for payment 90 days from invoice. But it is not fine if credit terms are 60 days, and it is alarming if credit terms are 30 days. Accounts receivable, unlike vintage wines or antiques, do not improve with age. Accounts receivable turnover should be in line with credit terms, and it signals increasing danger to liquidity as turnover gets further out of line with credit terms.
In the case of accounts receivable turnover, the numerator was Credit Sales. But for inventory turnover, the numerator is Cost of Goods Sold. The reason is that both accounts receivable and sales are measured in terms of the selling price of the goods involved. That makes the accounts receivable turnover a consistent ratio where the numerator and the denominator are both expressed at selling prices, in an apples-to-apples manner. By the same token, inventory turnover is an apples-to-apples comparison, where the numerator, Cost of Goods Sold, and the denominator, Inventory, are both expressed in terms of the cost, not the selling price, of the goods.
In our example, the inventory turnover is 5, or about every 70 days. In the auto retailing industry or the furniture manufacturing industry, that would be an acceptable result. However, in the supermarket business or in gasoline retailing, it would be extremely unsatisfactory, in comparison with their norms of about 25 times a year, or roughly every two weeks. Inventory turnover is usually evaluated in terms of what is typical for the industry in question. Just as was the case for accounts receivable turnover, an inventory turnover ratio that is out of line is a red flag.
This shows that, on average, accounts payable turn over six times a year, or around every 60 days. Again, note the consistency of the numerator and denominator, which are both stated at the cost of the goods purchased. Accounts payable turnover is evaluated by comparison with industry norms. An accounts payable turnover that turns out to be appreciably faster than the industry norm is fine, provided that liquidity is satisfactory, because prompt payments to suppliers usually earn cash discounts, which, in turn, lower the cost of goods sold and thus lead to higher income.
However, accounts payable turnover that is faster than the industry norm diminishes liquidity, and is therefore not wise when liquidity is tight. By the same token, accounts payable turnover that is slower than the industry norm enhances liquidity, and is therefore wise when liquidity is tight, but inadvisable when liquidity is fine, because it sacrifices cash discounts from suppliers and thus reduces the resulting income.
This concludes our survey of the ratios relating to short-term liquidity. By way of summary, the five ratios are:. If these ratios are seriously deficient, our diagnosis may be complete. The subject business may be almost insolvent, and even desperate measures may be insufficient to revive it.
In contrast, if these ratios are favorable, short-term liquidity does not appear to be threatened, and the financial doctor should proceed to the next set of tests, which measure long-term solvency. However, it is worth noting that there are some rare exceptions to these guidelines. For example, large gas and electric utilities typically have current ratios of less than 1, and quick ratios of less than 0.
This is due to exceptional characteristics of those utility companies:. Customers are reluctant to go without necessities such as gas and electricity, and therefore tend to pay their utility bills ahead of most other bills. These factors sharply reduce the risk of uncollectible accounts receivable for gas and electric utility companies. In turn, the ratios indicating short-term liquidity become less important.
Short-term survival is not a significant concern for these businesses. There are two commonly used ratios relating to servicing long-term debt.
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One ratio measures the ability to pay the interest, while the other reflects the ability to repay the principal. The ratio for interest compares the amount of income available for paying interest with the amount of the interest expense. This ratio is called interest coverage or times interest earned.
The amount of income available for paying interest is simply earnings before interest and income taxes are paid bear in mind that business interest expense is deductible for income tax purposes, and therefore income taxes are based on earnings after interest, otherwise known as earnings before income taxes. Earnings before both interest and taxes are known as EBIT. This shows that the subject business has EBIT sufficient to cover two times the interest expense.
The cushion, or margin of safety, is therefore quite substantial. Whether or not the interest coverage ratio is acceptable depends on the industry. Different industries have different degrees of year-to-year fluctuations in EBIT. Interest coverage of two times may be satisfactory for a steady and mature firm in an industry with stable earnings, such as regulated gas and electricity supply. However, when the same industry experiences the uncertain forces of deregulation, earnings may become volatile, and interest coverage of 2 may prove to be inadequate.
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Also, in the more turbulent industries, such as movie studios and Internet retailers, interest coverage of 2 may be regarded as insufficient. The long-term capital structure of a firm is made up principally of two types of financing: 1 long-term debt and 2 owner equity. There are some hybrid forms of financing that mix some characteristics of both debt and equity. But these hybrids usually can be classified as mainly debt or mainly equity in nature, so the distinction between debt and equity is normally clear.
Long-term debt is frequently secured by liens on property, and has priority on payment of periodic interest and repayment of principal. In contrast, there is no priority for equity in regard to dividend payments or return of capital to owners. Holders of long-term debt have a high degree of security with respect to receiving full and punctual payments of interest and principal, but they are not entitled to receive any more than these fixed amounts.
In good times or bad, that is all that is due to them. They have reduced their risk of loss in exchange for more certainty. Owners of equity enjoy no such certainty. They are entitled to nothing, except if and when any dividends might be declared, and, in the case of bankruptcy, to whatever funds might be left over after all obligations have been paid. Theirs is a totally at-risk investment.