Video Transcript: Liquidity Ratios

Hello, welcome. We're going to discuss liquidity ratios. So how do we use ratios  to analyze a business? First, different ratios explain different aspects of a  company. Ratios are used for the following purposes, evaluating the ability to  pay current liabilities and long term debt, evaluating, evaluating the ability to sell  merchandise, inventory and collect receivables, evaluating profitability and  evaluating stock as an investment. How do we use ratios to analyze the  business? So this is an example of an income statement. Notice we have  current assets. I'm sorry. I need to run this back. Let's start over on this slide.  Hold on, let's start over. No no after I said evaluating stock as an investment  from the first slide. So I'm going to switch slides and go to the second slide.  Okay, sorry about that, 4, 3, 2, so how do we use ratios to analyze a business?  You'll see here an example of a balance sheet dated December 31 2018, and  2017 so these are projected out into the future 2018 you'll see in the balance  sheet how we're separated out through assets, liabilities and stockholders  equity. So this is where we're going to derive the data that we need for our ratios here. So all of these ratios are intertwined into our company to understand how  well positioned we are to ensure that we can stay solvent, that we're going to  stay profitable, and we have enough cash to make sure that we can stay in  operation and cover our debt obligations. So here's an example of an income  statement as well, right? It's just going, this is where we're going to pull our data  from to plug into these equations, right? And then we'll explain what these  equations mean, and why do we run these ratios? So evaluating the ability to  pay current liabilities. So we're going to look at working capital first. So working  capital measures the ability to meet short term obligations with current assets.  So short term obligations are short term notes payable, accounts payable,  anything that's a short term within one year debt obligation that we have, we  want to make sure that our current assets, which is our inventory, we have  enough current assets or inventory to pay down our short term obligations. And  this is defined as working capital. So let's work working capital example. So I'll  show you where we will derive our numbers from. So let's go back to this slide.  So let's look at current assets, total current assets, right? So we've got in 2017,  total current assets, 236,000 in 2018 our current assets are 262,000 so we'll  solve for 2018 and we'll solve for 2017 so 2018 right? Our current assets,  262,000 minus current liabilities. Current liabilities. You'll also see total current  liabilities under the liabilities page, under the liabilities section on the balance  sheet, you'll see that current liabilities are made up of accounts payable,  accrued liabilities and notes payable. Those added together are total current  liabilities. So for 2018 we're going to subtract out 142,000. This gives us  $120,000 in working capital. This is a positive number. This is good, right? So  our current assets, 262,000 our current liabilities, 142,000 so we are able to  cover our current liabilities with our current assets. So because our current  liabilities are lower value than our current assets, we're positioned well to ensure

that we can cover our liabilities and stay in operation. So go back to 2017 same  calculation, right? 236,000 is our our current assets minus the liabilities. 126,000 equals 110,000 so we are well positioned in 2017 and in 2018 to cover our  current liabilities with current assets. Current assets, again, inventory, working  capital, things like that. Okay? Current Assets, cash and cash equivalents,  accounts receivable, merchandise, inventory and prepaid expenses are  example of current assets on this balance sheet. So current ratio, the most  widely used ratio is the current ratio. This ratio measures a company's ability to  pay its current liabilities with its current assets. So we're going to find out the  ratio right. So we've computed, okay, look, we got working capital. We know  we've got enough. So now we need to find our ratio right. We need to see now, if you'll notice in this graphic, the industry average is .60. So inside our average  inside our industry, the average company can cover their total liabilities, their  total current liabilities .6 times. Okay, so they can cover their current liabilities .6  times. That means they have more assets by .6, or 50% 60% as much right,  60% more assets than they do in liabilities. This is what this means. The industry average .60 so that they have six on average, a company in our industry has  60% more current assets than they do current liabilities. So let's look at our  current ratio and see where we are. So total current assets, again, let's derive  2018, total current assets, 262,002 it. Now we want to divide by current liabilities to get the ratio. Okay, so 142,000 as our total current liabilities. So now we want  to divide 262,000 divided by 142,000 this will give us 1.85 so now we can cover  our current liabilities with our current assets 1.85 times. That means we have  185% more assets than we do liabilities. Notice, our industry average is .6,  right? Industry average equals point six. We are. We are three times better than  the industry. So we are, with this current ratio, we are in great shape to cover  our liabilities, stay profitable and continue to grow. Let's work 2018 just as a  further example, or 2017 so again, 236,000 current assets over current  liabilities. 126,000 I should say, total current assets and total current liabilities.  So we're right. So in 2017 we were able to cover our liabilities 1.87 times, or we  have 187% more assets than we do liabilities. The cash ratio is an x. We'll  discuss this. The cash ratio helps determine a company's ability to meet its short term obligations. What are short term obligations? Total current liabilities? Let's  go back up and refresh what total current liabilities consist of. So total current  liabilities, accounts payable, accrued liabilities, notes payable, notice, these are  all short term debt obligations, nothing over a year, right, accounts payable,  those are usually in 15, 30, 45, 60, day terms. Whereas accrued liabilities, it's  just a liability over time that is accrued from other debt and notes payable short  term debt instrument that's less than one year. So you can see these are the  current liabilities. Now let's figure out the cash ratio. So we want to make sure  that we. Can meet our short term obligations with the cash that we have on  hand. Notice, this is different than the working capital and the current ratio 

calculations, as we were worried about current assets right, which included cash and inventory right and prepaid services here, they're also depending on current assets, but here, this is the cash ratio. We only want to know. Is our free cash  going to be enough to cover our total current liabilities, so that way, we don't  have to worry about dipping into our inventory revenue. Once we sell that, we  won't have to apply that directly to paying down our short term obligations,  because we have enough cash to cover it. So let's see how healthy of a cash  position our company is in. So let's look at cash and cash equivalents. Let's go  back up so cash and cash equivalents. For us, we have 29,000 in 2018 so 2018  we have 29,000 in cash and cash equivalents. Okay, and now we want to divide  that by total current liabilities. Now, our total current liabilities for 2018, again,  142,000 if so now we want to divide the 29,000 by 142,000 which gives us .20.  Now let's take a look at what the industry average is. Will notice the industry  average is .4, so we are below the industry average. So our cash, cash position  is not as strong as the industry right? We need to understand why our cash is  below the current industry average, right? So do we have too much debt? It  doesn't look like it. Our assets are good. Our current ratio is really strong. So our debt, or at least our current liability debt is in good position, right? Let's see  about our long term debt position. How are we looking here? So long current,  long term debt liabilities. You can see in 2018 if you look in the liability section  underneath where it says total current liabilities, you'll see the row entitled Long  term liabilities. Now you'll notice that it increased from 198,000 in 2017 to  289,000 to 2018 it's a big leap in long term liabilities. So now we have got these  long term obligations that we just undertook that we've got to pay down with  cash. So now we're burning through cash to pay down liabilities, and because of our long term.of because of our long term liability position, increasing that  position by almost $100,000 that is obviously put downward pressure on our  cash position, which makes us only be able to cover our 20% of our total current liabilities with cash, while the rest of The industry is able to cover 40% of their  current total liabilities. We are in 2018 because of the increase of our long term  debt position and the downward pressure on our free cash flow due to outflows  of cash to pay down debt, we now are in a worse position than we were in 2017  let's look at this so cash and cash equivalents in 2017 32,000 right? This is 2017 divided by 126,000 so Okay, and we're going to find out that it's .25, right? So  our cash position is decreased considerably, while even our total current  liabilities increased. So. Not only did our cash and cash equivalents decrease, in 2018 our total current liabilities increased by 16,000 and our total long term debt liabilities increased by 100,000 so in 2018 we're going to see some downward  pressure on our free cash flow is going to put us in a slightly worse position than we were in 2017 in order to pay down total current liabilities. Now let's look at  the acid test or the quick ratio. The acid test ratio, sometimes called the quick  ratio, tells us whether a company can pay all its current liabilities if they come 

due. So we need to know, can we pay down all of our current liabilities with  everything that we have as far as assets are concerned, cash, short term  investments and net current receivables? So so the short term investments are  typically stock, potentially, right? So we can sell shares of stock very easily and  convert that stock to cash, right? And then our net current receivables, which is  usually on a 15, 30, 45, 60, day basis, right? We're going to be able to calculate  that in because we're going to, we're going to get that cash from those  receivables within a short amount of time, right? So we can use that as  calculating cash flow right in the short term. So now we want to know if we can  pay off total current liabilities with the cash that we have. Can we pay them off  with the cash that we have or assets that can be converted to cash quickly? So  let's look at this. All right, 2018 so let's look at cash and cash equivalents. We've already established that right with the cash ratio for 2018 so let's look over here,  right? We're going to do this over here, 2018 so our cash and cash equivalents,  29,000 plus short term investments. We don't have any right now, our company  is not making any short term outside investments, all right, plus net current  receivables. Where are we going to find that? At we're going to find that next we  need to find a net current receivables. Net current receivables you'll find on the  balance sheet. You'll look at row two underneath current assets, accounts  receivable. Net accounts receivable for 2018 is 114,000 so let's add that in plus  114,000 so we'll add these up. We'll add these up 290,114 and then we'll divide  by total current liabilities, which we already know, 142,000 so our ratio, our quick ratio, for this for our company, right? This is going to tell us if we can pay all of  our total current liabilities right away, if they come due immediately. Okay, so this is going to allow us to see, can we pay off our total current liabilities if they come due. Now, do we have enough cash for this? Right? So we'll add this up so we  have 143,000 okay, this equals 143,000 divided by 142,000 equals 1.01 so yes,  we can cover our total current liabilities with our cash cash equivalents and net  current receivables 1.1 time. So we can cover it fully one time, and then by 1%  greater we can so we're we are inking out just enough cash, cash equivalents  and net current receivables to cover our total current liabilities for 2018 now for  2017 similar calculation, exact same calculation 2017 So we've got 32,000 and  cash and cash equivalents, plus zero short term investments plus 85,000 in net  receivables. Okay, we're going to divide that 126,000 Okay, so now 32,000 plus  85,000 is 117,000 so now we've got 117,000 divided by 126,000 so right now I  can already tell you we don't have enough cash to cover our current liability. 117  is less than 126 so our ratio will be 0.93 now if you want to compare ourselves  to the industry the industry average is .46, so we're doing considerably better  than the industry average. So even though, in our cash ratio, we're kind of  suffering a little bit. We're not doing so well because we run on that extra debt,  right? So, and we're in her actually performing below the industry average with  the quick ratio, we're performing considerably above the extra app the industry 

average. What we didn't include in the cash ratio was our net current  receivables. Now with the amount of net current receivables that we have, even  though our cash position declined in 2018 114,000 and net current receivables  is a big increase by almost 30,000 29,000 from 2017 so that's what helped us  put ourselves over being able to cover our total current liabilities, total with cash  so the industry average point .46 they can cover their current total liabilities.  Only 46% of your total current liabilities can be covered by using the cash  included with cash equivalents, short term investment and net current  receivables.