INTRODUCTION

TO SHORT-TERM
LIQUIDITY
ANALYSIS
Chapter 8
CHAPTER 8 OBJECTIVES
 Define liquidity and explain its role in
financial statement analysis.
 Relate financing and investing decisions
to the elements of the balance sheet.
 Distinguish between short-term and
long-term financing and investing
activities.
CHAPTER 8 OBJECTIVES
(CONT.)
 Identify, calculate and interpret liquidity
measures for working capital, current
account activity, and inventory-related
conversion cycles.
 Conduct a preliminary short-term
liquidity analysis of a company or
industry.
THE OBJECTIVE OF SHORT-
TERM LIQUIDITY ANALYSIS
 Liquidity--an entity’s ability to pay its
obligations when they are due
 Short-term liquidity
 conventional meaning of liquidity
 connotes payment of short-term
obligations with cash produced from
operations
 does not disrupt productive capacity
THE OBJECTIVE OF SHORT-
TERM LIQUIDITY ANALYSIS
 Objective—determination of an entity’s
ability to reimburse the contributors to
the core earning processes in a timely
manner
FINANCING AND INVESTING
ACTIVITIES
 Balance sheet
 reports the status of financing and
investing activities at a point in time
 Financing activities (liabilities and
shareholders’ equity) provide capital for
investing activities (assets)
FINANCING AND INVESTING
ACTIVITIES (CONT.)
 Primary business model (Exhibit 8-1)
 Captures the essence of the initial funding
of an entity
 Company acquires funds from investors
and allocates them to productive resources
FINANCING AND INVESTING
ACTIVITIES (CONT.)
 Operating business model (Exhibit 8-2)
 Captures the essence of the continual funding of
an entity
 Distinguishes between long and short-term
financing activities
 Relates long and short-term financing activities to
long and short-term investing activities
 Examines the convertibility of current assets into
cash in the near-term
TERMS AND CONCEPTS
 Operating cycle (Exhibit 8-3)
 Length of time required to convert a
current asset into cash
 Measures inventory transfer into
receivables and ultimately cash for
manufacturers and merchants
TERMS AND CONCEPTS
(CONT.)
 Operating cycle
 Measures length of time a service entity
needs to collect on services rendered
(absence of inventory)
 Conversion time is usually less than one
year (this text makes this assumption)
TERMS AND CONCEPTS
(CONT.)
 Current accounts
 Current assets—cash or resources that will
be converted into cash (or consumed in
the case of prepaid expenses) within one
year
 Current liabilities—obligations paid in cash
or otherwise satisfied within one year
TERMS AND CONCEPTS
(CONT.)
 Working capital
 Initial measure of short-term liquidity
 Computation: current assets – current
liabilities
LIQUIDITY MEASURES
(CONT.)
 Current (working capital) ratio
 Computation: average current assets /
average current liabilities
 General interpretation—large ratio
indicates sufficient liquidity; small ratio
could mean liquidity problems
LIQUIDITY MEASURES
(CONT.)
 Factors affecting current ratio
 Industry in which the firm operates
 Ability to sell inventory and collect
receivables
 Timing of cash collections and payments
LIQUIDITY MEASURES
(CONT.)
 Quick ratio
 Computation: (average current assets less
inventory and prepaid expenses) / average
current liabilities
 General interpretation—conservative
measure of short-term liquidity
 Drawback—unrealistic assessment of the
value of inventory
LIQUIDITY MEASURES
(CONT.)
 Activity measures
 Activity (turnover) ratio—quantifies the number of
times a liquid account turns over in the ordinary
course of business
 Number of days in a current account—measures
the length of time needed to sell, collect, or pay
for a current account
 Complementary measures: activity measures and
number of days both report an aspect of a current
account’s liquidity
LIQUIDITY MEASURES
(CONT.)
 Inventory activity measures
 Inventory turnover—number of times
inventory is sold during a reporting period
 Computation: cost of goods sold / average
inventory
 General interpretation—the greater the turnover
the better
 Number of days in inventory—length of time
needed to sell inventory
 Computation: 365 days / inventory turnover
 General interpretation—the lower the number of
days the better
LIQUIDITY MEASURES
(CONT.)
 Accounts receivable measures
 Accounts receivable turnover—number
of times accounts receivable are
collected in a reporting period
 Computation: revenues / average accounts
receivable
 General interpretation—the greater the
turnover the better
LIQUIDITY MEASURES
(CONT.)
 Number of days in accounts receivable
inventory—length of time needed to
collect accounts receivable
 Computation: 365 days / accounts
receivable turnover
 General interpretation—the lower the
number of days the better
LIQUIDITY MEASURES
(CONT.)
 Inventory conversion cycle
 Quantifies the operating cycle
 Computation: days in inventory + days in
accounts receivable
 General interpretation—the lower the
number of days in the cycle the better as
current assets are quickly converted into
cash
LIQUIDITY MEASURES
(CONT.)
 Accounts payable turnover—number of times
accounts payable are paid in a reporting
period
 Computation: cost of goods sold / average
accounts payable
 General interpretation—the lower turnover the
better
 Number of days in accounts payable—length
of time needed to pay vendors
 Computation: 365 days / accounts payable
turnover
 General interpretation—the greater the number of
LIQUIDITY MEASURES
(CONT.)
 Net cash conversion cycle
 Quantifies the financing period of current
accounts
 Computation: days in inventory + days in
accounts receivable – days in accounts
payable
 General interpretation—the lower the
number of days in the cycle the better as
less capital is invested in working capital
eSTUFF’S SHORT-TERM
LIQUIDITY RATIOS
Liquidity Ratios 2003 2002 2001
Working capital $ 481 $ 442 $ 257
Working capital ratio 4.45 5.42 2.80
Quick ratio 2.21 2.74 1.17
Inventory turnover 2.64 2.77 2.93
Days in inventory 138.02 131.99 124.43
Accounts receivable turnover 7.82 7.87 9.23
Days in accounts receivable 46.67 46.36 39.54
 eSTUFF’S SHORT-TERM
LIQUIDITY RATIOS (CONT.)

Liquidity Ratios 2003 2002 2001

Inventory conversion cycle 184.69 178.35 163.97
Accounts payable turnover 8.42 11.06 6.29
Days in accounts payable 43.34 33.00 58.07
Net cash conversion cycle 141.34 145.35 105.91
LIQUIDITY ANALYSIS OF THE
PC INDUSTRY
 Working capital analysis
 Working capital accounts dominate the
industry’s balance sheets (Exhibit 8-5)
 Current ratios decreased over the period
examined (Exhibit 8-6)
LIQUIDITY ANALYSIS OF THE
PC INDUSTRY (CONT.)
 Activity and cycle analysis
 Increases in inventory turnover (decreases
in days needed to sell inventory) was the
primary reason for the decline in the
current ratios (Exhibits 8-7 and 8-8)
 Inventory conversion and net cash
conversions cycles decreased over time
Exhibits 8-12 and 8-13)
 Exhibit 8-7
Days in Inventory for the PC Industry
1994-1998

80
70
Days in Inventory

60
50
40
30
20
10
0
1994 1995 1996 1997 1998

Apple Computer, Inc. Compaq Computer Corp.

Dell Computer Corp. Gateway 2000 Inc.
 Exhibit 8-12
Inventory Conversion Cycles for the PC Industry
1994-1998
Inventory Conversion Cycle (days)

140

120

100

80
60

40

20

0
1994 1995 1996 1997 1998

Apple Computer, Inc. Compaq Computer Corp.

Dell Computer Corp. Gateway 2000 Inc.
 Exhibit 8-13
Net Cash Conversion Cycles for the PC Industry
1994-1998

120
Net Cash Conversion Cycle (days)

100

80

60

40

20

0
1994 1995 1996 1997 1998
-20

Apple Computer, Inc. Compaq Computer Corp.

Dell Computer Corp. Gateway 2000 Inc.
 Exhibit 8-14
Conversion Cycles for Apple Computer
1994-1998
75 100 125 150
Conversion Cycles (Days)
50
25
0

1994 1995 1996 1997 1998

Apple's Inventory Conversion Cycle Apple's Net Cash Conversion Cycle

LIQUIDITY ANALYSIS OF THE
PC INDUSTRY (CONT.)
 Overall assessment
 Data suggest that all firms were able to
meet their maturing obligations
 Dell and Gateway were in more favorable
liquidity position than Apple and Compaq,
according to the evidence