Assignment: SEC10K Project- Liquidity
This SEC 10K project will look more in-depth at liquidity. In a previous assignment, you calculated the current ratio. A similar ratio, but more stringent measure of a company's ability to pay currently maturing debt or generate cash for operations, is the quick ratio (also called the acid-test ratio):
Quick Ratio = Quick Assets / Current Liabilities
Quick assets include cash, short-term investments in marketable securities, and net accounts receivable. Notice that the quick ratio excludes inventory and prepaid expenses in the numerator. Quick assets are those that will generate cash for the company more quickly. Inventory is two-steps away from being cash; first it must be sold and then the accounts receivable must be collected.
Prepaid expenses do not generate cash since the account represents cash paid in advance for rent, insurance, etc.
If quick assets exceed current liabilities, the quick ratio indicates the number of times the company can pay its currently maturing debt. A quick ratio of 1.5 means that the company can cover its current liabilities one and a half times or pay all of its current liabilities and still have quick assets remain. If quick assets are less than current liabilities, the company can only cover a portion of its current liabilities. For example, a quick ratio of 0.88 means the company can pay 88% of its liabilities.
One explanation for an increasing current ratio (normally a favorable trend) and a decreasing quick ratio (unfavorable trend) is that inventories are growing which could be a signal that the company is having trouble selling its inventory. If the company is having trouble collecting accounts receivables both the current ratio and the quick ratio will be higher since both include receivables in the numerator, but the company may not be in a good position to pay current liabilities. This suggests that interpreting the results of ratios requires judgment. Also, it illustrates that looking at one ratio in isolation is rarely useful.
Turnover ratios also provide information on liquidity. The faster a company can ‘turn over' its accounts receivable (i.e. the number of times it collect accounts receivable in a year) and inventory (i.e. sell inventory) the better its liquidity.
Accounts Receivable Turnover = (Net Credit Sales / Average Accounts Receivable, net) (if credit sales not available, use net sales)
Average accounts receivable = (Beginning Accounts Receivable* + Ending Accounts Receivable) / 2
*This year's beginning balance of accounts receivable is last year's ending balance. Inventory Turnover = (Cost of Goods Sold / Average Inventory)
Average Inventory = (Beginning Inventory + Ending Inventory) / 2
For both ratios, an increasing turnover is favorable.
Dividing the turnover ratios into 365, gives an indication of the number of days the receivables are outstanding and the average age of inventory:
Age of receivables = 365/Accounts Receivable turnover
Average age of inventory = 365/Inventory Turnover
Lower is better for both of these ratios. The longer receivables are outstanding the higher the likelihood of uncollectability. The longer inventory remains unsold the greater its susceptibility for spoilage or obsolescence.
Keep in mind, the results of these ratios are industry specific. For instance, auto manufacturers will turn over their inventory slower than a grocery store. Compare a company's ratio to its previous year's ratios or to an industry average rather than comparing to a company's ratios from another industry (this applies to any ratio, not just for liquidity).
A signal that a company is having liquidity problems is receivables and inventory growing faster than sales.
To calculate the percentage increase or decrease in a financial statement number
% change = (This year's number / Last year's number) - 1 x 100
For example, last year's net sales = $125,000 and this year's net sales = $130,000:
% change in sales = ($130,000 / $125,000) -1 x 100 = (1.04 - 1) x 100 = 0.04 x 100 = 4% increase
If last year's net sales = $125,000 and this year's net sales = $120,000 (sales decreased):
% change in sales = ($120,000 / $125,000) -1 x 100 = (0.96 - 1) x 100 = (0.04) x 100 = 4% decrease
Do this for net sales, accounts receivable, and inventory to determine if accounts receivables and inventories are growing faster than sales.
Required:
a. Calculate the current ratio, quick ratio, accounts receivable and inventory turnover ratios, the age of receivables and inventory for this year and last year. Make a table for the results and indicate whether the changes are favorable or unfavorable. Since your current SEC 10K report may not have the beginning balances for inventory or accounts receivable to calculate averages for the previous year, you may substitute the ending balance for the average for the previous year only.
b. Calculate the percentage change in sales, accounts receivable, and inventory from the previous to the current year. Are sales increasing faster than accounts receivable and inventory? Or are accounts receivable and inventory growing faster than sales? Make a table for the results (either the same table as above or in a separate table).
d. Comment on the company's liquidity, taking into account all of the ratios. For instance, is the current ratio increasing while the quick ratio is decreasing? Or are both increasing or both decreasing? Remember if current ratio is increasing and quick ratio is decreasing it could suggest the current ratio is of poor quality due to growing inventories. Are sales growing faster or slower than accounts receivable and inventory? Draw an overall conclusion and in a few sentences support your conclusion with the result of the analysis. If the results are mixed, it is okay to say so.
For all three parts, show your calculations either in the main table or in a separate exhibit.