Liquidity and Working Capital Current Ratio -Applications Ratio Management(window dressing) Examples are Press the collection of receivables at year-end Call in advances to officers for temporary repayment Reduce inventory below normal levels Delay normal purchases Proceeds from these activities are then used to pay off current liabilities
Ratio Management (window dressing) Examples are: • Press the collection of receivables at year-end • Call in advances to officers for temporary repayment • Reduce inventory below normal levels • Delay normal purchases Proceeds from these activities are then used to pay off current liabilities Liquidity and Working Capital Current Ratio - Applications
Liquidity and Working Capital Current Ratio- Applications Rule of Thumb Analysis (2:1) 2:1> superior coverage of current liabilities(but not too high, suggesting inefficient use of resources and reduced returns) <2:1> deficient coverage of current liabilities
Rule of Thumb Analysis (2:1) > 2:1 → superior coverage of current liabilities (but not too high, suggesting inefficient use of resources and reduced returns) < 2:1 → deficient coverage of current liabilities Liquidity and Working Capital Current Ratio - Applications
Liquidity and Working Capital Current Ratio- Applications Net Trade Cycle Analysis t Working capital requirements are affected by its desired inventory investment and the relation between credit terms from suppliers and those extended to customers
Net Trade Cycle Analysis Working capital requirements are affected by its desired inventory investment and the relation between credit terms from suppliers and those extended to customers Liquidity and Working Capital Current Ratio - Applications
Liquidity and Working Capital Current Ratio- Applications Net Trade Cyclelllustration Selected financial information from Technology Resources, Inc, for the end of Year 1 is reproduced below: Sales for Year 1 $360,000 Receivables 40,000 Inventories 50,000 Accounts payable 20,000 Cost of goods sold (including depreciation of $30,000) 320,000 Beginning inventory is $100,000 tWe assume these relate to purchases included in cost of goods sold We estimate Technology Resources' purchases per day as Purchases per day =$240,000=360=$666.67 The net trade cycle for Technology Resources is computed as(in days): s40000 Accountsreceivable 40.00 days s360,000÷360 50,000 56.24 days s320,000÷360 96.24 days Less: Accountspayable= $20,000 30.00 days s666
Net Trade Cycle—Illustration Selected financial information from Technology Resources, Inc., for the end of Year 1 is reproduced below: Sales for Year 1 $360,000 Receivables 40,000 Inventories* 50,000 Accounts payable† 20,000 Cost of goods sold (including depreciation of $30,000) 320,000 *Beginning inventory is $100,000. †We assume these relate to purchases included in cost of goods sold. We estimate Technology Resources’ purchases per day as: Purchases per day = $240,000 ÷ 360 = $666.67 The net trade cycle for Technology Resources is computed as (in days): Liquidity and Working Capital Net trade cycle(days) = 66.24 days = 30.00 days $666.67 $20,000 Less : Accountspayable = 96.24 days = 56.24 days $320,000 360 $50,000 Inventories = = 40.00 days $360,000 360 $40,000 Accountsreceivable = Current Ratio - Applications
Liquidity and Working Capital Current Ratio -Applications Sales Trend Analysis Trend analysis- review of sales trend across time
Sales Trend Analysis Trend analysis — review of sales trend across time Liquidity and Working Capital Current Ratio - Applications