MERCER BAA 510 - Liquidity Ratios - Short-Term Solvency (10 pages)

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Liquidity Ratios - Short-Term Solvency



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Liquidity Ratios - Short-Term Solvency

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Pages:
10
School:
Mercer University
Course:
Baa 510 - Fundamentals of Accounting and Finance
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Liquidity Ratios Short Term Solvency Current Ratio 2002 2001 Current assets Current liabilities The current ratio is a commonly used measure of short run solvency the ability of a firm to meet its short term debt requirements as they come due The available cash resources to satisfy these obligations must come primarily from cash or the conversion to cash of other current assets such as accounts receivable and inventories Accounts receivable and inventory may not be truly liquid A firm could have a relatively high current ratio but not be able to meet demands for cash because the accounts receivable are of inferior quality or the inventory is salable only at discounted prices Quick Ratio 2002 2001 Current assets inventory Current liabilities The quick ratio is a more rigorous test of short run solvency that the current ratio because the numerator eliminates inventory considered the least liquid current asset and the most likely source of losses Cash Flow Liquidity Ratio 2002 2001 Cash Mkt Securities CFOa Current liabilities a Cash flow from operating activities Another approach to measuring short term solvency is the cash flow liquidity ratio which considers cash flow from operating activities from the statement of cash flows The cash flow liquidity ratio uses in the numerator as an approximation of cash resources cash and marketable securities which are truly liquid current assets and cash flow from operating activities which represents the amount of cash generated from the firm s operations such as the ability to sell inventory and collect the cash It is helpful to compare this ratio to the current and quick ratios Contradictory pictures between this ratio and other liquidity ratios should be investigated thoroughly because ultimately companies need cash to pay high bills High current and quick ratios combined with low or negative cash flow liquidity ratios could signal problems Cash Flow From Operation One of the most important numbers in all of the financial statements is Cash Flow From Operations It is important to evaluate a firm s success over time by identifying the underlying causes for the trends and the fluctuations of a firm s cash from operations The relative comparisons of cash provided from operations and the net income over time will frequently give an indication if the company is managing earnings One of the best indications of earnings management is when the growth of net income is up and smooth and the trend of cash from operations is not Over time these numbers should track in the same manner The cash flow from operations are taken directly from the cash flow statement Accounts Receivable Turnover 2002 2001 Net sales Accounts receivable Inventory Turnover 2002 2001 Cost of goods sold Inventory Payables Turnover 2002 2001 Cost of goods sold Accounts payable The accounts receivable inventory and payables turnover ratios measure how many times on average accounts receivable are collected in cash inventory is sold and payables are paid during the year These three measures are mathematical complements to the ratios that make up the net trade cycle and therefore measure exactly what the average collection period days inventory held and days payable outstanding measure for a firm they provide an alterative way to look at the same information Average Collection Period 2002 2001 Accounts receivable Average daily sales The average collection period for accounts receivable is the average number of days required to convert receivables into cash This ratio helps gauge the liquidity of accounts receivable the ability of the firm to collect from customers It may also provide information about a company s credit policies For example if the average collection period is increasing over time of is higher than the industry average the firm s credit policies could be too lenient and accounts receivable not sufficiently liquid The loosening of credit could be necessary at times to boost sales but at an increasing cost to the firm On the other hand if credit policies are too restrictive as reflected in an average collection period that is shortening and less than industry competitors the firm may be losing qualified customers Days Inventory Held 2002 2001 Inventory Average daily cost of sales The days inventory held is the average number of days it takes to sell inventory to customers This ratio measures the efficiency of the firm in managing its inventory Generally a low number of days inventory held is a sign of efficient management the faster inventory sells the fewer funds are tied up in inventory However too low a number could indicate understocking and lost orders a decrease in prices a shortage of materials or more sales than planned A high number of days inventory held could be the result of carrying too much inventory or stocking inventory that is obsolete slowmoving or inferior such as increased demand expansion or an expected strike Days Payable Outstanding 2002 2001 Accounts payable Average daily cost sales The days payable outstanding is the average number of days the firm takes to pay accounts payable in cash This ratio offers insight into a firm s pattern of payments to suppliers An optimal strategy is to delay payment of payables as long as possible but still make payment by the due date in order to avoid finance charges Net Trade Cycle 2002 2001 Average collection period days inventory held days payable outstanding The net trade cycle measures the normal cash conversion cycle of a firm which consists of buying or manufacturing inventory with some purchases on credit creation of accounts payable selling inventory with some sales on credit creation of accounts receivable and collecting cash from accounts receivable Changes in the net trade cycle help explain why cash flow generation has improved or deteriorated by analyzing the key working capital accounts accounts receivable inventory and accounts payable The shorter the net trade cycle the more efficient the firm is in managing its cash Activity Ratios Asset Liquidity and Asset Management Efficiency Fixed Asset Turnover 2002 2001 Net sales Net property plant and equipment Total Asset Turnover 2002 2001 Net sales Total assets The fixed asset turnover and total asset turnover ratios are two approaches to assessing management s effectiveness in generating sales from investments in assets The fixed asset turnover considers only the firm s investment in property plant and equipment and is extremely important for a


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