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Accounting Allah shmoop Day today Balance sheet care and feeding

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Okay people So let's put some mathematical meat on the

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bones of our balance sheet and map a means for

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viewing liquidity Well some of this may feel familiar It's

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going to be a slightly similar ish take on what

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we've already gone over just to drive a few points

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home So no you're not having deja vu But if

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that sounds good to you so we can check in

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the kitchen don't get caught up in five dollar words

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and fancy Where'd accounting terms When you think about basic

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concepts like Can I pay my freakin bills That concept

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is easy You pay your rent or you live in

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your ninety three Chevy Cash management Or more broadly balance

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sheet management is a big focus for accountants mainly because

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if there ever isn't enough cash in the till well

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that the company ends up here Okay we're cutting our

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balance sheet meat with a sharp knife So let's start

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at the butt steak part here First up on the

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liquidity rack The current ratio Yeah keyword current as in

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meaning within the next year Current ratio is a measure

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of what we got against what we owe Based on

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current I'ii short term assets and liabilities ones we only

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have to worry about for the next year But we

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have to worry about two things The ratio itself Obviously

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we want more assets than liabilities and how big the

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numbers are Like if we run a pastry shop and

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we have one hundred grand in short term assets but

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a million bucks in short term liabilities well then we're

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probably like months or weeks or minutes from bankruptcy When

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everyone comes to collect their bills or death or whatever

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it is we eloped If the same word true of

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one hundred million dollars revenue company of pretty good margins

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well then met Probably not a huge deal Those numbers

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were so small and weaken Digest them without a lot

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of grief And no they're not good But they're not

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grave inducing either Probably so what's a quote Good ratio

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unquote of short term assets Short term liabilities Well one

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No one is clearly dangerous But what about three toe

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won a million bucks in short term assets and only

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three hundred grand in short term liabilities like you have

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a million dollars in cash in your handy dandy B

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of a account And in total you on ly o

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three hundred grand Teo pay off everything Well at least

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all of your short term debts That's probably pretty good

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right At least you can sleep at night And this

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week anyway three to one Good one Good one Dangerous

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One two three Probably dead Yeah something like that Okay

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Another slab of meat Let's go for the prime rib

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here Accounts receivable You know we love those Love it

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Love it When people owe us money for product we've

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already sold them well Most accounts receivable are short term

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assets It's pretty rare to sell something and then not

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be owed that dough for over a year Presumably people

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will pay you within the next year You can always

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count on it Note that a lot of companies carry

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accounts receivable It's a net number meaning that they assume

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there will be a certain number of people who are

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not goingto pay the dough They Oh maybe the payers

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will go bankrupt and yet end up here Maybe they'll

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claim their religion tells them they're not required to pay

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not allowed here Whatever the reason they're going to end

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up being deadbeats So the company makes an estimated guess

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as to the number that will fail to pay and

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figures that number into their net calculations Usually there's some

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history behind the number like in the last five years

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the company average five percent bad account So if they're

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actually owed one hundred million dollars well they show accounts

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receivable as ninety five million having netted out five million

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for the likely deadbeats All right Aki Metric you'll need

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to know is accounts receivable Turnover that is you sell

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something to a customer who has to pay you in

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ninety days Well it's great that you made the sale

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but that sale cost you liquidity and that you had

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to use your precious usually scarce cash resources to buy

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inventory pay people to assemble the product ship it You

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deal with contracts and all that So at the moment

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of sale the sale actually sucked up your cash And

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you can imagine that if you were net three sixty

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five instead of net ninety well you could get very

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illiquid very fast with all your cash in the product

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That you sold the people who aren't going to pay

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you for a year So metering and measuring how quickly

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your accounts receivable Hey you is a big deal and

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the ratio was calculated as follows You take annual credit

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sales like things not sold for cash right away like

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on a credit card or I'll pay you later with

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an IOU divided by accounts receivable at the beginning of

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the year Okay Sochi Vocabulary concept Fact door companies use

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factors when they need cash Today not later But now

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a factor is essentially someone who buys in accounts receivable

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So for example if you have just sold four thousand

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pounds of neoprene to scuba doo for say a hundred

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grand But that hundred grand won't be paid to you

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for two months or so and there's a little bit

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of risk to it You might want to get the

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cash sooner rather than later so you'll pay pay up

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for the certainty In this case a fact door would

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give you a piece of paper allowing you to legally

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sign over to the fact or the right to receive

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that hundred thousand dollars Whenever the neoprene Byers said they

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would pay for it And that factor has the same

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rights you would have in going after the neoprene buyer

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to collect that money In return for that piece paper

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The factor might pay you in ninety eight thousand dollars

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right now Today cash So you're getting two percent less

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than you would have otherwise But you're getting the money

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two months sooner than you would have doing Rough math

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The factor for their grief is essentially making a one

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percent per month or twelve percent per year Annualized return

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on your money Taking a bit of risk their right

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there getting that one percent a month in payment in

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return for providing cash liquidity to you Yep Inventory is

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a liquid asset but inventory can and probably should be

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held on the balance sheet at a big discount What

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the company paid for it Okay Backto our friendly lemonade

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stand Suppose you bought a million cops at a dining

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each And if you had to suddenly turn them into

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cash Could you really get a diamond cup for them

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Like really Probably not The would be buyers would smell

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your desperation And there isn't a natural liquid market for

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semi used cups Smart companies negotiate with their vendor's a

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return policy something on the order of wealth I have

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the right to send back to you half of whatever

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I bought and get ninety five percent of what I

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paid you No questions asked Yeah something like that And

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that's our vendors talk And in accounting for all that

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will you just do the math and carry the net

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number or net value of that inventory on your book

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But the key idea here is that inventory isn't always

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liquid and often when it's converted into cash especially in

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an emergency situation there's a steep discount that you pay

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All right the four elements that comprise current assets or

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sorry our cash securities accounts receivable and inventory Yeah Zari

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So how did the current ratio even get born Well

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once upon a time a current assets and a current

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liability met And then they danced It was a mating

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ritual where the current asset climbed on top of the

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current liability and they did a calculation Yeah specifically they

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created a little baby current ratio It's a cute little

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bug oven accounting term which basically describes how fast we're

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paying our bills relative to collecting them Let's think about

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this All right If we had a ratio of one

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to one that would imply that five minutes after we've

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collected a bill we've paid what we owe What happens

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if someone who Oh Zack's money says Sue me I

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don't owe you the bill Yeah all right Well we

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might win after we sue him but it'll take months

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or years to go to cord and deal with lawyers

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and judges and a bizarre American legal system and will

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likely go bankrupt long before we collect the fourteen thousand

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two hundred thirty two dollars we are owed In fact

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in the real world the common tool large companies use

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against smaller ones with little to no leverage our maneuvers

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like this where they just hold up the back of

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their hand and tell the little companies Teo you know

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Reed between the lines so one to one current ratio

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is bad Bad news What is a good ratio Well

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think about three to one If we're analyzing a company

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and we note that it pays its bills really quickly

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That's a sign that the company feels great about its

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cash position that it will have plenty of dough left

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over at the end of the month to pay rent

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and not have to work out of the back of

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you know corporate pickup truck Well what about a current

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ratio of twenty to one What does that mean Well

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it means you have tons of current assets few current

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liabilities and well does that mean there's too much money

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tied up in inventory Yeah maybe We don't know We

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have to think about our peer group The industry risk

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volatility whole bunch other things Because why Well because ding

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ding ding these numbers don't exist in a vacuum right

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That is if your company has ten million dollars in

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revenue with current assets of one point five billion dollars

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and current liabilities of one billion dollars Well that's one

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point five to one current ratio right on the edge

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of bad But look at the magnitude How is it

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that you have only ten million dollars of revenue and

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such huge balance sheet items One tiny wrinkle to the

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bad and you're dead meat There's another ratio that speaks

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directly to liquidity The quick ratio not to be confused

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with the nest quick ratio which is way more delicious

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Well it's called the quick ratio as a reflection of

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some hand out in front vendor or saying Pay me

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and then you being ableto quickly pay them That works

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clever well The quick ratio is all about immediate cash

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That is how quickly could you come up with whatever

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amount of cachet there for defensive or offensive purposes Defense

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You lose a lawsuit If you agree to pay all

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of it off immediately you can pay half of what

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the judged amount wass agree not to appeal And well

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then the lawsuit goes away Offense A competitor wants to

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get out from his business a s a P Maybe

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the founder is sick or in the middle of a

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midlife crisis in just took delivery of his convertible red

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Porsche And if you pay X dollars today ish in

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cash well then you can have his business for a

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steel You could buy it for half What Get it

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market So we bludgeon view with what comprised current assets

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cash securities accounts receivable and inventory Which of these is

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not like the other Yeah inventory if you need cash

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quick Well you don't wanna have to be selling inventory

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to get there Selling inventory usually ain't all that quick

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And while it's technically a current asset the notion of

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current is broadly defined when it comes to a thousand

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spare tractor treads Usually there's not even a category for

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tractor treads on eBay in some Wall Street bars and

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bean counter coffee counters while the quick ratio is called

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the acid test But if someone quotes you acid test

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I'll check to be sure they're wearing shoes It's highly

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likely they attended a you know Woodstock All right Another

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ratio we have think about is de esos or days

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sales outstanding It is calculated as accounts receivable over sales

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made on credit Poof What does that mean Well you'll

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notice if you aren't asleep yet that this is sort

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of the inverse ratio of the accounts receivable turnover calculation

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We just did Again it's all relative A big de

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eso number means that it's taking us forever to collect

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our doe That's not a good sign usually but a

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jet engine company might make a sale and not deliver

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the full engine for like two years albeit with partial

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payments made along the way so you can't compare it

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to a lemonade stands CSOs right Well the basic idea

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here is just that if you are collecting your bills

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relatively quickly well that's good And if you're not that's

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bad And in real life most financial managers pay a

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lot more attention to relative trends within a company or

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in industry Then they do the external world meaning that

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if last quarter de esos were thirty seven and suddenly

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this quarter there forty one well then Houston we may 00:11:46.679 --> [endTime] have a problem

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