If you have been following us over the last several weeks we have been reviewing the financial report for the years 2007 and 2008 for the fictitious company Acme Combustion. Beginning this week we will examine a number of financial ratios to measure the health of Acme. First we will look at short-term solvency.
A company must have sufficient cash resources to stay in business. Liquidity means survival, and insufficient liquidity means bankruptcy. The short-term solvency of a company can be measured using some financial ratios. The
current ratiois total current assets divided by total current liabilities. A current ratio of >1.0 is needed for a margin of safety. At year-end 2008, Acme’s current ratio was 21,875/21,975 = 1.0 approximately. That’s marginal.
The next ratio we look at is turnover of assets. This is theaccounts receivable turnover. This is the (total sales/Accounts Receivable), assuming all sales are on credit. For the year 2008, 33,000/5,000 = 6.6, which means that receivable are “turning over” on the average of 6.6 times per year. It can be expressed in days by dividing 365 by 6.6, or 55 days. This is OK if our terms are 60 days, but not so good if they are 30 days. Receivables, unlike good wine, do not age well. The longer they go out, the more likely they will become uncollectible.
Inventory turnis the cost of goods sold/inventory. Inventories are carried on the balance sheet at cost. For Acme the ratio is 20,800/16,725 = 1.24. Dividing that into 365 shows that we have 293 days of inventory! This should be totally unacceptable. This is a serious red flag as to Acme’s short-term liquidity and must be addressed immediately.
TheAccount payable turnover= (Cost of goods sold/accounts payable). This ratio indicates how well we are paying our suppliers and for 2008 is 20,800/6,950 = 3.0 times per year, or converted into days is 120 days. How many suppliers are going to keep us as a customer with that performance? We are going to also get a very bad credit rating.
As we have seen when we looked at the cash flow, there are significant short-term liquidity problems with Acme even though we have been making a wonderful profit every year! As we said when we began this exercise, reported “profit” is definitely NOT the whole story.