Analysis of Financial Statements - Liquidity of Short Term Assets
A company must maintain its ability to pay its current obligations and also have a sound base to sustain in the long run. In any case, if a company cannot make immediate arrangements for clearing its current liabilities, the creditors can force it to go into bankruptcy. Dubai World is a mega company with over $100 billion of assets. But it is facing a financial nightmare as it does not have enough funds to pay $4 billion of dues to the banks and bondholders. Most of its funds are stuck up in real-estate which cannot be easily liquidated to pay the current liabilities.
There is a close relationship between the current assets and the current liabilities of a firm. The current liabilities should be paid with cash generated by efficient use of assets or internal cash. Paying current liabilities by raising long-term loans would complicate the problem.
In this hub, an attempt would be made to describe procedures for analyzing liquidity position of a company.
What is a liquidity?
Liquidity refers to access to cash to keep the operations going. Most businesses work in a cyclical way. At each point of the cycle, cash is needed for purchase of raw materials, for paying wages to workers, for payment of the utility charges. If there is a shortage of cash at any point, the operations would come to a grinding halt.
To survive, the cash-outflow should be outbalanced by a larger cash-inflow. In other words, there must always a positive cash or bank balances at all times.
What is profitability?
Profit is difference between sales and costs in a wider sense. More profit may not result in more cash since sales are made on credit and profit is calculated on accrual basis. In this way, a profitable company may go into troubles for not having enough cash to ensure its day to day operations.
Trade off between profitability and liquidity?
A depositor gets more profit by keeping its funds with a bank for a long-term. If so, the depositor sacrifices liquidity. If the funds are in a current account, it is like a cash-in-hand. Withdrawing cash from a term account is not smooth and takes time in calculation. Also, the banks may insist on an adequate notice for such withdrawals.
Similarly, if a business sells on credit for a longer period, it would attract a lot many customers willing to pay somewhat higher price. But it would block the funds for a longer period and as such liquidity would suffer. In addition, the chances of bad debts would increase because of the longer credit periods.
CARE IN USE OF RATIOS
- Case Study on Financial Soundness
A case study showing misleading ratios.
watching both liquidity and profitability
Simply put, lack of profitability and lack of liquidity are two major reasons for a business failure. An unprofitable business would be eating up its own resources and would not last longer. On the other hand, a company may be profitable but may fail because of cash crisis. In bad time, the banks freeze stocks pledged with them, sell off securities left with them at a throw-away price and refuse to extend any further loans. Besides, names of the defaulters are circulated to all banking system by credit information bureaus. As such no other bank could help the company to come out of troubled waters. There is an old proverb: When troubles come they come not in single spies but in battalion. So a company must watch both its profitability as well as liquidity.
Current assets (i) are in the form of cash, (ii) will be realized in cash or (iii) conserve the use of cash within the operating cycle of a firm or one year, whichever is longer. The operating cycle of a company is the duration between purchase of raw materials, converting it to finished goods and finally cash realization on sales. Current Assets normally consist of:
- CASH - coin, currency notes and un-restricted funds on deposit with a bank. At any time, cash must be enough to pay for wages, utilities bills and loan instalment in the next one or two months. Also, a company should have a un-used line of credit in case of any emergency.
- Marketable securities - called cash equivalent, these securities are not only liquid but also earn some profit through dividends or gain on sales thereof.
- Trade Receivables - keeping in line with the industrial norm, a company has to extend credit. A company should carefully examine background of the debtors before extending any credit. Also recovery efforts should be made immediately when account becomes overdue. An allowance must be kept to account for un-collectibles or bad debts based on duration of defaults, background of the debtors and leverages, if any.
- Inventories consist of raw material stock, work-in-process, finished goods and stores. Sometimes, their valuation poses a problem. Four methods are used (i) specific identification, (ii) weighted average, (iii) FIFO and (iv) LIFO. (FIFO method is mostly used which means "First-In First-Out".)
- Besides, there are other current assets like prepayments, advances and deposits and other receivables.
As of December 31, 2008 Packages Ltd had current assets totalling Rs.5.617 billion as against Rs.1,965 billion in the previous year. The surge in magnitude is due to rise in inventories costs which, in turn, can be attributed to higher production costs following hyper inflation.
Current liabilities are obligations expected to be liquidated within the next 12 months. Since these are expected to be paid by the cash generated through use of current assets, there is a positive correlation between current assets and current liabilities. Current Liabilities include:
- Bank Loans for shorter period secured against pledge or hypothecation of stocks.
- Accounts payables on account of acquiring raw materials on credit.
- Expense payable mostly bills of utility companies and markup.
- Taxes payable
- Dividend payable, and
- Current Maturities of Long Term Debt.
In case of Packages Ltd, the current liabilities were Rs.5,617 billion in 2008 as against Rs.1.965 billion in 2007. The increase in current liabilities was mainly due to a massive increase in bank loans for inventory financing.
NET WORKING CAPITAL
This is the difference between current assets and current liabilities of a company. Net working capital expands with profitable operations as internal cash is used to purchase marketable securities and paying of high-cost short term loans. With each profitable production cycle, the networking capital would go on expanding as more and more cash would be thrown in. On the contrary, the same cash would be thrown out with unprofitable operations which may lead the company to stop its operations and opt for winding up.
Basically, there are two liquidity ratios: (i) Current Ratio and (ii) Acid-Test Ratio or Quick Ratio. These are described below:
Current ratio is obtained by dividing current assets with current liabilities. The current assets of Packages Ltd were Rs.6,908 million and current liabilities were Rs.5,617 million, the current ratio being 1.23:1. This means that for every rupee of current liabilities, the current assets were Rs.1.23. This is a marginal ratio but the company has a good reputation and the banks or raw-material suppliers would not feel panicky. (The same ratio in 2007 was 2.46:1)
The current ratio is used extensively in financial reporting. However, while easy to understand, it can be misleading in both a positive and negative sense - i.e., a high current ratio is not necessarily good, and a low current ratio is not necessarily bad. All depends on the composition of current assets and current liabilities. If current assets are mostly liquid and current liabilities contains soft loans like loans from allied concerns, a negative ratio can be OK. On the other hand, if current assets have large inventories and stuck-up advances while the current liabilities are mainly bank loans, a positive current ratio would still be bad.
Also called Acid Test Ratio, is a refinement of current ratio. Here inventories are deducted from current assets as these are not readily saleable. The quick ratio shows immediate availability of cash to pay for current obligations. Under this scenario, forced sale of inventories may bring a substantial loss and, hence, these are excluded from computation.
As would be seen from the side table, the quick ratio has sharply dropped to 0.43:1 in 2008 from an ideal position of almost 1:1 in the previous year. However, the current liabilities in 2008 include Rs.1.02 billion which were directly associated with non-current assets classified as "held for sale - advances against sale of shares". If this amount is excluded from the current liabilities, the quick ratio would improve to 0.53:1. Further, the company has ample cushion as its investments in property and share are over Rs.10 billion.
Limitation of Liquidity Ratios
Both current ratio and quick ratio are based on figures from the balance sheet. Ratios which are based on a single source do not represent a fair picture. As stated earlier, positive ratios may be bad and negative ratios could be tolerable. Those ratios are considered creditable which are based on more than one source such as balance sheets, income statements and cash flows. Efficiency ratios, which would be described later, are good indicators as these are based on all the three sources i.e. income statement, balance sheet and cashflow.
A study of Industrial environments is of paramount importance in passing any judgement over the adequacy of ratios. If prospects of industry are good, even week ratios would be acceptable. Moreover, diversified customers and a large number of suppliers strengthen the position of a company as it is not dependent on one customer or supplier.
It may be mentioned that ratios are just indictors. They do not provide the absolute answers but suggest questions that need be answered.
Liquidity plays a vital role in survival of a business. Some describe it as solvency but it would be better if the term 'solvency' is reserved for "ability to survive in the long run." This would, in turn, depend on the capital structure of a company. If a company is highly geared i.e. its debts are much more than its equity base, it would not survive the first economic down-turn.
A company should always keep itself in an adequate state of liquidity by keeping adequate cash, marketable securities and good trade debtors. Cash management is a skill which must be developed by all concerned to survive in the short and the long run.
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