Introduction Optional Reading Workshop Content - Bivio

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RAW - Liquiditybanks, Current maturity of long term debt and the Current portion ofcapital lease payments.Other listed by Value Line includes everything else that contributes tocurrent liabilities.The three components of current liabilities used by Value Line areadequate for this workshop and will be used for the examples thatfollow.S&P shows the Current Assets, Current Liabilities and Current Ratio foreach of the past ten years. S&P does not show the components of eitherCurrent Assets or Current Liabilities.CURRENT RATIO EXAMPLE 1This example illustrates the influence of short term debt on thecurrent ratio.Assume that two companies, A and B, have the components of CurrentAssets and Current Liabilities shown below. The two companies areidentical except that Company B has 100 (million) of Debt Due.Data For Current Ratio Examples 1 and 2Company ACompany BCash 100 100Accounts Receivable 100 100Inventory 100 100Other 0 0------------------------------------------------Total Current Assets 300 300Accounts Payable 100 100Debt Due 0 100Other 0 0----------------------------------------------Total Current Liabilities 100 200Current Ratio 3 1.5The degrading influence of having Debt Due is apparent.CURRENT RATIO EXAMPLE 2This example illustrates that long term debt does not influence thecurrent ratio.Looking back to example 1 assume that Company B still has 100 millionof debt, but that it is not due within one year. The debt might not bedue for two years or even twenty years. In any case there is no DebtDue for either company and they both will have a current ratio of 3.Does this represent a failure of the current ratio? Keep in mind thatthe current ratio is intended to measure short-term liquidity. Theeffect of long-term debt is detected by the Leverage Ratios that willbe discussed later in this workshop. This example does illustrate whyit is important to look at a set of ratios and not rely on the value ofjust one ratio.CURRENT RATIO EXAMPLE 3Page 3
RAW - LiquidityThis example illustrates that just looking at the value of the currentratio is not always adequate.Assume that Company A has developed a problem on its production line.The items coming out the end of the production line are defective insome way. Some of the items are being held for re-work before they canbe sold. Some defective items have been sold and the customers areholding back payment until the problem is corrected. AccountsReceivable and Inventories are increasing. Cash is decreasing. Thesituation is illustrated in the following table.Data For Current Ratio Example 3Company ACash 0Accounts Receivable 150Inventory 150Other 0Total Current Assets 300Accounts Payable 100Debt Due 0Other 0Total Current Liabilities 100Current Ratio 3The Current Ratio is still 3, but the ability of Company A to pay itsbills has definitely decreased. Does this represent a failure of theCurrent Ratio? Possibly. In practice the company would probably haveslowed down in paying its Accounts payable and/or borrowed some moneyso Debt Due would no longer be zero. Either approach would tend tolower the Current Ratio. Even so, the Current Ratio is not always agood ratio for detecting problems associated with Accounts Receivableand Inventory. We will return to this example when Turnover Ratios arediscussed.PEER REVIEWThe Market Guide Ratio Comparison report dated 01/16/98 shows thatPepsiCo has a Current Ratio of 0.67 and Coca-Cola has a Current Ratioof 0.91 compared to an industry average of 0.84.Part 8 will cover the Quick Ratio.+++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++From: glsimms@juno.comSubject: Re: Ratio Analysis <strong>Workshop</strong>-Part 7To: i-club-list@better-investing.orgDate: Mon, 02 Feb 1998 13:34:55 ESTI think that this comment really should be made after part 8 of theTutorial but since Jay has so nicely listed the components of CurrentAssets and Current Liabilities, I will make it here.As I believe we will see in the next tutorial, the Quick ratio makes anattempt to remove an item (inventory) that is more difficult to convertto cash in an effort to show just how much cash the company can come upwith on short notice.Last weekend I bought a programmed workbook that runs you throughsome basic ratio calculation. It is: The Motley Fool InvestmentPage 4
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