LECTURE 1

FINANCIAL RATIOS: Liquidity Ratios

Liquidity ratio – these ratios give us an idea of the firm’s ability to pay off debts that are maturing within
a year or within the next operating cycle. Satisfactorily, liquidity ratios are necessary if the firm is to
continue operating.

Formulas:

a. Current ratio – measures the ability of the business to pay its short-term obligations as they fall due.
Primary test of solvency to meet current obligations from current assets as going concern; it’s a measure
of adequacy of working capital.

Total Current Assets

Current Ratio
Total Current Liabilities

b. Quick ratio – otherwise known as acid test ratio, measures immediate liquidity with the ability to pay
current liabilities with the most liquid assets. The quick ratio is a more conservative measure of liquidity
since it only considers current assets that can converted to cash easily and quickly.

Cash + ST investments + Trade Receivables

Quick Ratio/ Acid test Ratio
Current Liabilities

c. Receivable Turnover – measures the efficiency to collect the amount due from credit customers.

Net Credit Sales

Receivable Turnover
Average Accounts Receivable

d. Average collection period – otherwise called as day’s sales outstanding, is the approximate number of
days it takes a business to collect its receivable from credit or account sales. In assessing whether the
average collection period is favorable or unfavorable, the credit terms extended by the company to its
customers should be considered.

360 days
Average collection period
Receivable Turnover
e. Inventory Turnover – measures the number of times a company’s inventory is sold and replaced
during the year.

Cost of goods sold

Inventory Turnover
Average Inventory

f. Average sales period – otherwise known as inventory conversion period, is the average time to
convert inventory to sales.

360 days
Average Sales Period
Inventory Turnover

g. Working Capital – measures the short-term liquidity of the company.

Working capital = Current Assets - Current Liabilities

DRILL 1

Albus Dumbledore Trading

Statement of Financial Position
As of December 31

2017 2016 2015

Assets
Current Assets

Cash 158,000.00 84,000.00 70,000.00

Short-term Investments 130,000.00 192,000.00 200,000.00

Accounts Receivable, net 240,000.00 200,000.00 180,000.00

Merchandise Inventory 500,000.00 530,000.00 550,000.00

Total Current Assets 1,028,000.00 1,006,000.00 1,000,000.00

Noncurrent Asset
Property, plant and Equipment 2,340,000.00 2,350,000.00 2,360,000.00

Total Assets 3,368,000.00 3,356,000.00 3,360,000.00

Liabilities and Owner's Equity

Current Liabilities

Accounts Payable 530,000.00 584,000.00 600,000.00

Noncurrent Liabilities

Loan Payable 800,000.00 840,000.00 860,000.00

Total Liabilities 1,330,000.00 1,424,000.00 1,460,000.00

Owner's Equity 2,038,000.00 1,932,000.00 1,900,000.00

Total Liabilities and Owner's Equity 3,368,000.00 3,356,000.00 3,360,000.00

Albus Dumbledore Trading

Income Statement
For the Years Ended December 31

2017 2016 2015

Net Sales 4,972,000,000.00 4,150,000,000.00 3,600,000,000.00

Cost of Goods Sold 3,046,000,000.00 2,444,000,000.00 2,200,000,000.00

Gross profit 1,926,000,000.00 1,706,000,000.00 1,400,000,000.00

Selling and Administrative Expense 1,556,000,000.00 1,500,000,000.00 1,200,000,000.00

Operating Income 370,000,000.00 206,000,000.00 200,000,000.00

Interest Expense 88,000,000.00 92,000,000.00 84,000,000.00

Income before Income taxes 282,000,000.00 114,000,000.00 116,000,000.00

Income tax expense 94,000,000.00 42,000,000.00 37,200,000.00

Net income 188,000,000.00 72,000,000.00 78,800,000.00

Compute the following:

a. Current ratio

b. Quick ratio

c. Receivable Turnover

d. Average collection period

e. Inventory Turnover

f. Average sales period

g. Working capital