Description
its a term used in financial mgmt
LIQUIDITY
Liquidity reflects the ability of a firm to meet its short-term obligations using those assets that are most readily converted into cash. Assets that may be converted into cash in a short period of time are referred to as liquid assets; they are listed in financial statements as current assets. Current assets are often referred to as working capital, since they represent the resources needed for the day-to-day operations of the firm s long-term capital investments. Current assets are used to satisfy short-term obligations, or current liabilities. The amount by which current assets exceed current liabilities is referred to as the net working capital.
LIQUIDITY
The Operating Cycle How much liquidity a firm needs depends on its operating cycle. The operating cycle is the duration from the time cash is invested in goods and services to the time that investment produces cash. For example, a firm that produces and sells goods has an operating cycle comprising four phases: 1. Purchase raw materials and produce goods, investing in inventory. 2. Sell goods, generating sales, which may or may not be for cash. 3. Extend credit, creating accounts receivable. 4. Collect accounts receivable, generating cash.
LIQUIDITY
What does the operating cycle have to do with liquidity?
LIQUIDITY
The longer the operating cycle, the more current assets are needed (relative to current liabilities) since it takes longer to convert inventories and receivables into cash. In other words, the longer the operating cycle, the greater the amount of net working capital required
LIQUIDITY
To measure the length of an operating cycle we need to know: 1. The time it takes to convert the investment in inventory into sales (that is, cash inventory sales accounts receivable). 2. The time it takes to collect sales on credit (that is, accounts receivable cash).
The operating cycle for a certain company can be calculated using the balance sheet and income statement data. The number of days a company ties up funds in inventory is determined by the total amount of money represented in inventory and the average day s cost of goods sold. The average day s cost of goods sold is the cost of goods sold on an average day in the year, which can be estimated by dividing the cost of goods sold (which is found on the income statement) by the number of days in the year.
Average day s cost of good sold
= Cost of goods sold 365 days = $6,500,000 365 days = $17,808 per day
The company has $1.8 million of inventory on hand at the end of the year. How many days worth of goods sold is this? Or How long would it take the company to run out of inventory?
The number of days of inventory is calculated as a ratio of the amount of inventory on hand (in dollars) to the average day s cost of goods sold (in dollars per day): Number of days of inventory = Amount of inventory on hand Average day s cost of goods sold = 1800000 / 17808 = 101 days
Therefore, similarly, one can calculate the number of days between a sale to the time it is collected in cash. If we assume that the company sells all goods on credit, then the average credit sales per day = Credit sales / 365 days Thus the company s number of days of credit = Accounts receivable / Credit sales per day = 600000 / 27397 = 22 days. Therefore Operating cycle = Number of days of inventory + Number of days of credit = 101 days + 22 days = 123 days
Similarly, We can apply the same logic to accounts payable as we did to accounts receivable and inventories. How long does it take a firm, on average, to go from creating a payable (buying on credit) to paying for it in cash? We need to determine the amount of an average day s purchases on credit. If we assume all the company s purchases are made on credit, then the total purchases for the year would be the cost of goods sold less any amounts included in cost of goods sold that are not purchases.
Average day s purchases = Cost of goods sold Depreciation 365 days = $6,500,000 $1,000,000 365 = $15,068 per day Therefore, Number of days of payables = Accounts payable Average day s purchases = $500,000 / $15,068 per day = 33 days This means that on average the company takes 33 days to pay out cash for a purchase.
Therefore the net operating cycle = Operating cycle Number of days of payables Net operating cycle = Number of days of inventory + Number of days of credit Number of payables Net operating cycle = 101 + 22 33 = 90 days The net operating cycle is how long it takes for the firm to get cash back from its investments in inventory and accounts receivable, considering that purchases may be made on credit. By not paying for purchases immediately (that is, using trade credit), the firm reduces its liquidity needs. Therefore, the longer the net operating cycle, the greater the required liquidity.
Measures of Liquidity
Current ratio =
Current assets Current liabilities = = $3,000,000 $1,000,000 3.0 times
Current ratio
Measures of Liquidity
An alternative to the current ratio is the quick ratio, also called the acid-test ratio, which uses a slightly different set of current accounts to cover the same current liabilities as in the current ratio. In the quick ratio, the least liquid of the current asset accounts, inventory, is excluded. Quick ratio = Current assets Inventory Current liabilities $3,000,000 1,800,000 = $1,000,000 = $1,200,000 $1,000,000 1.2
Quick ratio
=
Measures of Liquidity
Another way to measure the firm s ability to satisfy short-term obligations is the net working capital-to-sales ratio, which compares net working capital (current assets less current liabilities) with sales: Net working capital-to-sales ratio = Net working capital Sales = $3,000,000 1,000,000 $10,000,000 = 20% The ratio of 0.20 tells us that for every dollar of sales, the company has 20 cents of net working capital to support it.
doc_575416708.pptx
its a term used in financial mgmt
LIQUIDITY
Liquidity reflects the ability of a firm to meet its short-term obligations using those assets that are most readily converted into cash. Assets that may be converted into cash in a short period of time are referred to as liquid assets; they are listed in financial statements as current assets. Current assets are often referred to as working capital, since they represent the resources needed for the day-to-day operations of the firm s long-term capital investments. Current assets are used to satisfy short-term obligations, or current liabilities. The amount by which current assets exceed current liabilities is referred to as the net working capital.
LIQUIDITY
The Operating Cycle How much liquidity a firm needs depends on its operating cycle. The operating cycle is the duration from the time cash is invested in goods and services to the time that investment produces cash. For example, a firm that produces and sells goods has an operating cycle comprising four phases: 1. Purchase raw materials and produce goods, investing in inventory. 2. Sell goods, generating sales, which may or may not be for cash. 3. Extend credit, creating accounts receivable. 4. Collect accounts receivable, generating cash.
LIQUIDITY
What does the operating cycle have to do with liquidity?
LIQUIDITY
The longer the operating cycle, the more current assets are needed (relative to current liabilities) since it takes longer to convert inventories and receivables into cash. In other words, the longer the operating cycle, the greater the amount of net working capital required
LIQUIDITY
To measure the length of an operating cycle we need to know: 1. The time it takes to convert the investment in inventory into sales (that is, cash inventory sales accounts receivable). 2. The time it takes to collect sales on credit (that is, accounts receivable cash).
The operating cycle for a certain company can be calculated using the balance sheet and income statement data. The number of days a company ties up funds in inventory is determined by the total amount of money represented in inventory and the average day s cost of goods sold. The average day s cost of goods sold is the cost of goods sold on an average day in the year, which can be estimated by dividing the cost of goods sold (which is found on the income statement) by the number of days in the year.
Average day s cost of good sold
= Cost of goods sold 365 days = $6,500,000 365 days = $17,808 per day
The company has $1.8 million of inventory on hand at the end of the year. How many days worth of goods sold is this? Or How long would it take the company to run out of inventory?
The number of days of inventory is calculated as a ratio of the amount of inventory on hand (in dollars) to the average day s cost of goods sold (in dollars per day): Number of days of inventory = Amount of inventory on hand Average day s cost of goods sold = 1800000 / 17808 = 101 days
Therefore, similarly, one can calculate the number of days between a sale to the time it is collected in cash. If we assume that the company sells all goods on credit, then the average credit sales per day = Credit sales / 365 days Thus the company s number of days of credit = Accounts receivable / Credit sales per day = 600000 / 27397 = 22 days. Therefore Operating cycle = Number of days of inventory + Number of days of credit = 101 days + 22 days = 123 days
Similarly, We can apply the same logic to accounts payable as we did to accounts receivable and inventories. How long does it take a firm, on average, to go from creating a payable (buying on credit) to paying for it in cash? We need to determine the amount of an average day s purchases on credit. If we assume all the company s purchases are made on credit, then the total purchases for the year would be the cost of goods sold less any amounts included in cost of goods sold that are not purchases.
Average day s purchases = Cost of goods sold Depreciation 365 days = $6,500,000 $1,000,000 365 = $15,068 per day Therefore, Number of days of payables = Accounts payable Average day s purchases = $500,000 / $15,068 per day = 33 days This means that on average the company takes 33 days to pay out cash for a purchase.
Therefore the net operating cycle = Operating cycle Number of days of payables Net operating cycle = Number of days of inventory + Number of days of credit Number of payables Net operating cycle = 101 + 22 33 = 90 days The net operating cycle is how long it takes for the firm to get cash back from its investments in inventory and accounts receivable, considering that purchases may be made on credit. By not paying for purchases immediately (that is, using trade credit), the firm reduces its liquidity needs. Therefore, the longer the net operating cycle, the greater the required liquidity.
Measures of Liquidity
Current ratio =
Current assets Current liabilities = = $3,000,000 $1,000,000 3.0 times
Current ratio
Measures of Liquidity
An alternative to the current ratio is the quick ratio, also called the acid-test ratio, which uses a slightly different set of current accounts to cover the same current liabilities as in the current ratio. In the quick ratio, the least liquid of the current asset accounts, inventory, is excluded. Quick ratio = Current assets Inventory Current liabilities $3,000,000 1,800,000 = $1,000,000 = $1,200,000 $1,000,000 1.2
Quick ratio
=
Measures of Liquidity
Another way to measure the firm s ability to satisfy short-term obligations is the net working capital-to-sales ratio, which compares net working capital (current assets less current liabilities) with sales: Net working capital-to-sales ratio = Net working capital Sales = $3,000,000 1,000,000 $10,000,000 = 20% The ratio of 0.20 tells us that for every dollar of sales, the company has 20 cents of net working capital to support it.
doc_575416708.pptx