18 Understanding the Numbers
- Cash Equivalents are near-cash securities such as U.S. Treasury bills ma-
turing in three months or less. - Accounts Receivable are amounts owed by customers and should be re-
ported on the balance sheet at “realizable value,” which means “the
amount reasonably expected to be collected in cash.” Any accounts whose
collectibility is in doubt must be reduced to realizable value by deducting
an allowance for doubtful debts. - Inventories in some cases may not be liquid in a crisis (except at fire-sale
prices). This condition is especially likely for goods of a perishable, sea-
sonal, high-fashion, or trendy nature or items subject to technological ob-
solescence, such as computers. Since inventory can readily lose value, it
must be reported on the balance sheet at the “lower of cost or market
value,” or what the inventory cost to acquire (including freight and insur-
ance), or the cost of replacement, or the expected selling price less costs
of sale—whichever is lowest.
Despite these requirements designed to report inventory at a realistic
amount, inventory is regarded as an asset subject to inherent liquidity
risk, especially in difficult economic times and especially for items that
are perishable, seasonal, high-fashion, trendy, or subject to obsolescence.
For these reasons the current ratio is often modified by excluding inven-
tory to get what is called the quick ratioor acid test ratio: - In the case of Nutrivite, the quick ratio as of December 31 is $40,600/
$40,000, or 1. This indicates that Nutrivite has a barely adequate quick
ratio, with no margin of safety at all. It is a red f lag or warning signal.
The current ratio and the quick ratio deal with all or most of the current
assets and current liabilities. There are also short-term liquidity ratios that
focus more narrowly on individual components of current assets and current li-
abilities. These are the turnover ratios, which consist of:
- Accounts Receivable Turnover.
- Inventor y Turnover.
- Accounts Payable Turnover.
Turnover, which means “making liquid,” is a key factor in liquidity. Faster
turnover allows a company to do more business without increasing assets. In-
creased turnover means that less cash is tied up in assets, and that improves
liquidity. Moving to the other side of the balance sheet, slower turnover of lia-
bilities conserves cash and thereby increases liquidity. Or more simply, achiev-
ing better turnover of working capital can significantly improve liquidity.
Turnover ratios thus provide valuable information. The working capital
turnover ratios are described next.
Quick RatioCurrent Assets Inventory
Current Liabilities= −