What is the limitation common to both the current and the quick ratio?

How can goal congruEnce for managers and shareholders be achieved?

goals of managers with the goals of shareholders 40 Business Finance Lecture 8 Review of the Previous Lecture 􀂄 Cash Flow Statement 􀂄 Financial Statements Analysis 􀂄 Significance 􀂄 Common Size Analysis Topics under Discussion 􀂄 Financial Statements Analysis 􀂄 Common Size Analysis (Cont.) 􀂄 Ratio Analysis 􀂄 Short-term solvency, or liquidity, ratios 􀂃 Current Ratio 􀂃 Acid Test (Quick) ratio 􀂃 Cash ratio Common-Size Statements 􀂄 One very common and useful way of standardized comparison is to work with percentages instead of dollars. 􀂄 So, a standardized financial statement presenting all items in percentages is called a commonsize statement. 􀂄 Balance sheet items are shown as a percentage of total assets and income statement items as a percentage of sales. A2Z Inc., Balance Sheet A2Z Inc. Balance Sheet as of December 31 ($ in millions) Assets 20X1 20X2 Current Assets Cash $ 84 $ 98 Accounts receivable 165 188 Inventory 393 422 Total $ 642 $708 Fixed assets Net plant and equipment 2,731 2,880 Total assets $3,373 $3,588 A2Z Inc., Balance Sheet Liabilities and equity 20X1 20X2 Current liabilities Accounts Payable $ 312 $ 344 Notes payable 231 196 Total $ 543 $ 540 41 Long-term debt 531 457 Stockholders' equity Common stock and paid-in surplus 500 550 Retained earnings 1,799 2,041 Total $2,299 $2,591 Total liabilities and equity $3,373 $3,588 A2Z Inc., Common-Size Balance Sheet Assets 20X1 20X2 Current Assets Cash 2.5% 2.7% Accounts receivable 4.9 5.2 Inventory 11.7 11.8 Total 19.1% 19.7% Fixed assets Net plant and equipment 80.9% 80.3% Total assets 100.0% 100.0% A2Z Inc., Common-Size Balance Sheet Liabilities and equity 20X1 20X2 Current liabilities Accounts payable 9.2% 9.6% Notes payable 6.8 5.5 Total 16.0% 15.1% Long-term debt 15.7% 12.7% Stockholders' equity Common stock and paid-in surplus 14.8% 15.3% Retained earnings 53.3 56.9 Total 68.1 72.2 Total liabilities and equity 100.0% 100.0% A2Z Inc., Common-Size Balance Sheet More on Standardized Statements Suppose we ask: "What happened to A2Z's net plant and equipment (NP&E) over the period?" 􀂄 Based on the 20X1 and 20X2 B/S, NP&E rose from $2,731 to $2,880, so NP&E rose by $149. 􀂄 Did the firm's NP&E go up or down? Obviously, it went up, but so did total assets. In fact, looking at the standardized statements, NP&E went from 80.9% of total assets to 80.3% of total assets. A2Z Inc., Common-Size Balance Sheet More on Standardized Statements 􀂄 If we standardized the 20X2 numbers by dividing each by the 20X1 number, we get a common base year statement. In this case, $2,880 / $2,731 = 1.0545, so NP&E rose by 5.45% over this period. 42 􀂄 If we standardized the 20X2 common size numbers by dividing each by the 20X1 common size number, we get a combined common size, common base year statement. In this case, 80.3%/ 80.9% = 99.26%, so NP&E almost remained the same as a percentage of assets. (. .) In absolute terms, NP&E is up by $149 or 5.45%, but relative to total assets, NP&E fell by 2.6%. A2Z Inc., Common-Size Balance Sheet More on Standardized Statements 􀂄 Current assets rose from 19.1% in 20X1 to 19.7% in 20X2 􀂄 Current liabilities declined from 16.0% to 15.1% of total liabilities and equity over the same time. 􀂄 Total equity rose from 68.1% of total liabilities and equity to 72.2%. 􀂄 Overall, A2Z's liquidity as measured by current assets compared to current liabilities, increased over the year. Also, A2Z's indebtness diminished as a percentage of total assets. 􀂄 So we may conclude that balance sheet as grown stronger A2Z Inc., Income Statement For the Year 20X2 ($ in millions) Net sales $2,311 Cost of goods sold 1,344 Depreciation 276 Earnings before interest and taxes $ 691 Interest 141 Taxable income 550 Taxes 187 Net income $ 363 Dividends $121 Retained earnings 242 A2Z Inc., Common-Size Income Statement Net sales 100.0 % Cost of goods sold 58.2 Depreciation 11.9 Earnings before interest and taxes 29.9 Interest 6.1 Taxable income 23.8 Taxes 8.1 Net income 15.7 % Dividends 5.2% Retained earnings 10.5 A2Z Inc., Common-Size Income Statement 􀂄 This statement tells us what happened to each dollar in sales. 􀂄 For A2Z interest expense eats up 6.1% of sales, while taxes take another 8.1% of sales figure. 􀂄 Following this, 15.7% of revenues from sales flow down to bottom as net income; one-third of which is paid in dividends and remainder two-thirds is taken as retained earnings for busniess. 􀂄 As far as cost is concerned, 58.2% of revenues are spent on the goods sold 43 Standardized Financial Statements 􀂄 Although an organization's common-size statements provide a better analytical insight into the it's strength and standing, yet it's performance and efficiency can be better judged by comparing these with those of the firm's competitors. Ratio Analysis 􀂄 Another way of avoiding the problems involved in comparing companies of different sizes, is to calculate and compare financial ratios. 􀂄 One problem with ratios is that different people and different sources frequently don't compute them in exactly the same way. 􀂄 While using ratios as a tool for analysis, you should be careful to document how you calculate each one, and, if you are comparing your numbers to those of another source, be sure you know how their numbers are computed. Ratio Analysis 􀂄 For each of the ratios we discuss, several questions come to mind: 􀂄 How is it computed? 􀂄 What is it intended to measure, and why might we be interested? 􀂄 What is the unit of measurement? 􀂄 What might a high or low value be telling? How might such values be misleading? 􀂄 How could this measure be improved? Ratio Analysis 􀂄 Financial ratios are traditionally grouped into the following categories: 􀂄 Short-term solvency, or liquidity, ratios 􀂄 Ability to pay bills in the short-run 􀂄 Long-term solvency, or financial leverage, ratios 􀂄 Ability to meet long-term obligations 􀂄 Asset management, or turnover, ratios 􀂄 Intensity and efficiency of asset use 􀂄 Profitability ratios 􀂄 Ability to control expenses 􀂄 Market value ratios 􀂄 Going beyond financial statements Short-Term Solvency, or Liquidity Measures 􀂄 The primary concern to which these ratios relate, is the firm's ability to pay its bills over the short run without undue stress. So these ratios focus on current assets and current liabilities. 􀂄 Liquidity ratios are particularly interesting to short-term creditors. Since financial managers are constantly working with banks and other short-term lenders, an understanding of these ratios is essential 44 Short-Term Solvency, or Liquidity Measures 􀂄 Current assets and liabilities 􀂄 Their book values and market values are likely to be similar. 􀂄 They can and do change fairly rapidly, hence unpredictable Current Ratio Current Assets Current Ratio= ------------------------ Current Liabilities 􀂄 Because current assets and liabilities are converted into cash over the following 12 months, the current ratio is a measure of short run liquidity. 􀂄 The unit of measurement is either dollars or times. Current Ratio 􀂄 For A2Z Corporation, the 20X2 current ratio is $708 Current Ratio= ---------- = 1.31 times $540 􀂄 We can say that 􀂄 A2Z has a $1.31 in current assets for every $1 in current liabilities OR 􀂄 A2Z has its current liabilities covered 1.31 times over. Current Ratio 􀂄 To a creditor (particularly a short-term creditor like supplier), the higher the current ratio, the better 􀂄 To firm, high current ratio indicates liquidity, but it may also indicate an inefficient use of cash and other short-term assets. 􀂄 We would expect to see a current ratio of at least 1, because a current ratio of less than 1 would mean that net working capital is negative Current Ratio 􀂄 Like any other ratio, current ratio is effected by various transactions. 􀂄 If a firm borrows over long-term, 􀂄 The short run effect would be an increase in cash as well as in long term liabilities. 􀂄 Current liabilities would not be affected, so the current ratio would rise. 􀂄 An apparently low current ratio may not be a bad sign for a company with a large reserve of unlimited borrowing power. 45 Current Ratio Current Events 􀂄 A firm wants to payoff some of its suppliers and creditors. What would happen to current ratio? 􀂄 Current ratio moves away from 1. if it is greater than 1 it will get bigger. But if it is less than 1, it will get smaller. 􀂄 Suppose a firm has $4 in current assets and $2 in current liabilities for a current ratio of 2. and uses $1 in cash to reduce current liabilities, then new current ratio is ($4-2) / ($2-1) = 3 􀂄 Reversing the situation to $2 in current assets and $4 in current liabilities, the change will cause current ratio to fall to 1/3 from 1/2 Current Ratio Current Events 􀂄 Suppose a firm buys some inventory. What would happen in this case? 􀂄 Nothing happens to current ratio. Because in this scenario, one current asset (cash) goes down while another current asset (inventory) goes up. Total current assets are unaffected. Current Ratio Current Events 􀂄 What happens if a firm sells some merchandise? 􀂄 Current ratio would usually rise because inventory is shown at cost and sale would normally be at something greater than cost (difference is markup). 􀂄 So, the increase in either cash or receivables is greater than the decrease in inventory. 􀂄 This increases current assets and current ratio rises. Quick (or Acid-Test) Ratio 􀂄 Inventory is often the least liquid current asset. And its book values are least reliable as measures of market value since the quality of inventory isn't considered. Some of the inventory may turn out to be damaged, obsolete or lost. 􀂄 Relatively large inventories are often a sign of short-term trouble. 􀂄 The firm may have overestimated sales and overbought or overproduced as a result, hence tied up a substantial portion of its liquidity in slow moving inventory Quick (or Acid-Test) Ratio 􀂄 It is computed just like current ratio, except inventory is omitted. Current Assets - Inventory Quick Ratio= ------------------------------------ Current Liabilities 􀂄 For A2Z, this ratio in 20X2 was $708 - 422 Quick Ratio= ----------------- = 0.53 times $540 46 Quick (or Acid-Test) Ratio 􀂄 The quick ratio here tells a somewhat different story than the current ratio, because inventory accounts for more than half of A2Z's current assets 􀂄 If the same figure is for an aircraft manufacturing corporation, then this would certainly be a cause for a BIG concern. Cash Ratio 􀂄 A very short-term creditor may be interested in the cash ratio Cash Cash Ratio= ----------------------- Current Liabilities 􀂄 Current ratio for A2Z in 20X2 was 0.18 Summary 􀂄 Financial Statements Analysis 􀂄 Common Size Analysis (Cont.) 􀂄 Ratio Analysis 􀂄 Short-term solvency, or liquidity, ratios 􀂃 Current Ratio 􀂃 Acid Test (Quick) ratio 􀂃 Cash ratio Upcoming topics 􀂄 Ratio Analysis (cont.) 􀂄 Long Term Solvency, or Liquidity ratios 􀂄 Asset management, or turnover, ratios 􀂄 Profitability ratios 􀂄 Market value ratios

What is the limitation common to both the current and the quick ratio?

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