Welcome to finance and

Excel video number 16. Hey, if you want to download

this workbook or the PDF, click on the link

directly below the video and you can download the

workbook and PDF for chapter 3. And we've got to talk

about liquidity ratios. Liquidity, what's liquidity? How quickly something

can be converted to cash. Can they cover their

short term bills? We talked about working capital. Working capital

is current assets minus current liabilities. But here's a ratio. We talked about it a little

bit in the last video, but more in the context

of learning ratios. Here we want to talk

about liquidity ratios, in particular, the current

asset, commonly used in debt contracts, where

you see the current asset has to be a certain

amount or perhaps they have to pay some of

their debt early. CA, current assets divided

by current liabilities– for every $1 of

current liability, how many dollars

of current assets are there for us to

potentially use that to pay? Now above– when we do

this division– above one is generally good.

If it was 10 divided

by 10, it's 1, which means we have 10

current assets for every 10 current liabilities. If it's 20 divided

by 10, that's 2. That means you have

more current assets. So that's pretty good. Below 1 is generally not good. Now it depends, as always. If it's a small business,

maybe they need more. If it's a large business or

the business has lots of access to borrowing funds, then

maybe below 1 is OK. Now notice it says

big corps, it's OK. In the financial crisis– let's see– Bear Stearns at the

height of it had 1 divided– well, I don't know what it was. But their debt, they had 40

times as much debt as equity. So I don't know what

their current ratio was. But it was well below 1. So sometimes, in that case,

it turned out to be not good.

But sometimes businesses

can get away with it. Usually common sense,

above 1 is good. There's a bunch

of interpretations of current asset. And we'll do a

bunch of examples. But here are some notes if

you want to look through them. They have little scribbles about

what happens if certain things, like if you incur long term debt

or if you pay off short term creditors. We're actually going to look

at these examples in Excel so you can read that

if you want later.

So current ratio– what about

the quick ratio or asset test? Same thing except for we

subtract out inventory. Why would we subtract

out inventory. Well, this takes a

little while to sell or maybe it may be hard

to sell or it's obsolete. So people take it out. And this is more

immediate measure of short term liquidity. Still, another ratio,

the cash ratio– we just take cash divided

by current liability– so that means, if you had

to pay it all off now, could you do it? Now let's go over to Excel

and look at an example. Here's our Whole Foods Market

example 2005 and '06 data. Let's go ahead and

calculate first for 2005 our current ratio. Equals, this is 2005– so we got our cash, accounts

receivable inventory, other, and then there's the total.

So that divided by our current

liabilities right there. So 1.6, we have $1.6

in current assets for every current liability. So that's looking pretty good. Now let's do for the next year. Here's our total

current assets divided by our total

current liabilities. So it went down a bit. Maybe they're selling

inventory more. Maybe they used up

some of their cash. As we saw from

the balance sheet, they actually bought

a bunch of assets.

So that makes sense

that it went down. Now let's take

out the inventory. Now it equals– and we're

going to open parenthesis because we need

to do subtraction before we do division. So I'm going to say,

total current assets. This is for– I'm actually supposed

to be doing 2006 here. So I'm going to go [SOUND]

that minus the inventory– a lot of inventory

for Whole Foods– divided by total current

liabilities, right there. That was 2006. Now let's do 2005. I kind of did that in reverse. We take our total current

assets minus our inventory and divide by total

current liabilities. So again, that makes sense too. It went down, if they're

using cash to buy assets. It makes sense

that it went down. Now let's do the

cash rate ratio. Here's all of our cash for 2005. We'll divide it by our

total current liabilities. Now if we had to pay

everything off right now, we have 82.5 cents in cash

for every $1 of liability.

That's not so bad. And then here for

2006, what happened? I bet you it went down. Let's see. So cash is right there divided

by total current liabilities. Well, so it went down a lot. So cash went down

a lot in relation to our current liabilities. Those are liquidity, how

bankers are going to look– if Whole Foods can pay

interest, suppliers are going to look, can they

pay their bills, et cetera. Now let's go talk about

what accountants and what the people

inside the firm can do to one measure, current ratio. Since this is in a

lot of contracts, people know how to

do a lot of things, or tricks right before

the balance sheet is prepared to maybe make their

current ratio look better. Now I'm going to click on

the sheet Current Ratio. And you can use this

sheet to go ahead and try these calculations for yourself.

I'm just going to go

through the end result. Now we want to look at

a bunch of situations. We want to say, what

happens to current ratio when we purchase inventory. Of course, the answer

is, it depends. And then we'll look

at three depends. I will say what happens

when a supplier is paid, when short term

bank loans are paid, and a bunch of other examples. And again, this is what can– in general, this is what happens

to the ratio when you do this. So if you're a manager

and it's important to have a certain current

ratio, then you need to be aware of what

these actions do to our ratio. What if we purchase inventory? Well, of course, it will

not change if you pay cash. And the reason why

is current assets– if you pay $1 cash, it's

going to go right back into inventory, $1.

They're both current assets. So nothing's going to change. We add some inventory. We decrease some cash. We go from a ratio of 2 to 2. Now if you pay on credit,

there's two possibilities. If your current ratio

is greater than one, it's going to go down. Let's see how. We start at four. Current assets, we

bought inventory. So it goes up by 1. So we end up with 5. Current liabilities,

AP goes up by 1. So it's 3. And 5 divided by 3 is 1.67,

which means it'll go down.

But notice we started above 1. If your current

ratio is below 1– so right now you have 0.8333

of current assets for every $1 of current liability. So it's less than 1. Now look what happens. We start at 5, let's say. Current assets, we add

inventory once we get 6. Current liabilities,

we're at six. We add 1 to that. We get 7. Well, 5 divided by 6 is 0.83. 6 divided by 7 is 0.85. It goes up. Next example– oh,

suppliers paid. Well, we're going

to pay some cash. So current assets

are going to go down and current liability

is going to go down. So we're paying a supplier. Not a long term debt– we'll

talk about that one later. Well, again, it depends. It depends on if current

ratio is greater than 1. So greater than 1– we have a current ratio of 2. So we start at

current assets of 1. Cash goes down by 1, we get 3.

Current liabilities are 2. We pay off $1 of that. We go down to 3. So what's 3 divided by 1? It's 3. So it went up. So yeah, that's what happens. Now the opposite happens if

we start at our current ratio below 1. So we start at 5,

cash goes down by 1. We get 4. Current liability is 6. We paid it off. So it was down to 5. 4 divided by 5 is 0.8. So it actually will go down. So that's what a

supplier is paid. Now short term bank loan– well, if it's short

term, then it's classified as current liability. And simply what's

going to happen is your cash goes down by $1. If you pay off, you

start at 4, you go to 3. Current liability,

it can be a loan. It goes down. So we end up with 1. So it goes from 2 to 3. Ah, but the same thing

just as a moment ago.

If we're starting off

less than 1, we had 5. We paid off a $1 of

cash, went down to 4. We had 6 current liabilities,

which included that loan. It went down by 1. We go to 0.8. Now long term debt. I'm going to scroll down here– long term debt paid early. Now it's important

that it's paid early because any long term debt

is on the balance sheet. But if any of it is due

within the next year, it gets moved to

current liabilities.

So it's only when you

pay something early. Here's what happens. Cash will go down by $1. So we start at 4. We go to 3. So we pay off– but why is the cash going down? Oh, because we

paid off some debt. But look at this. The current liability

stays the same. That didn't change. It was the long term debt. So we go from 4 to 3. 2 to 2, no change.

We get a ratio of 1.5. So that the current

ratio will go down when you pay off

long term debt early. Now what about if AR is paid? Well, it's kind

of a wash, right? Because current assets, we have

accounts receivable and cash. So cash goes up by

$1, but AR goes down. So there's no change. What about inventory,

sold at cost? Now usually you don't sell

inventory at cost, right? But if you do, what happens? Well, again it's a wash. Cash goes up by $1. Inventory goes down. Remember, inventory

is recorded usually at what you bought it for. So in this case, inventory down,

exactly what we paid, cash in. So there's no change. But if we sell inventory at

a profit, well, we like that. Look at this, cash goes up by 2. We sold it for $2. Inventory goes down by $1. So we go from 4. We actually have to add,

just to show you the formula.

We take the 4– oh yeah, we add the cash

by 2, which is to 6, subtract 1, we get 5. Current liability is the same. So it goes up from 2 to 2.5. Finally, if companies

are in trouble sometimes, they're right on the cusp. They're not supposed to have

their current ratio go down, and they're about to

post their balance sheet. Well, what do they do? They issue long term debt

to pay off short term debt. So really what they're doing

is they go out and get– let's say they owe 10,000

in current liabilities. They go out and take a

long term loan and pay off. So really, they're transferring

long term debt or short term debt and putting it into

the long term category.

So what happens here? Well, current assets

don't change at all. Even though the cash

comes in from the loan, immediately it goes off to

pay the current liability. So it goes from 4 to 4. Ah, but if you pay off that

CL, Current Liability– let's say $1, it

goes from 2 to 1– it dramatically increases. So sometimes people

will do this trick right before the balance

sheet is supposed to be created in order to

raise up their current ratio.

Perhaps they were about

to violate some contract or something like that. That's a little bit

about current ratio. In our next video, we'll come

back and do turnover ratios– a lot of really

cool creative ratios that get interesting information

from financial statements. See you next video..